Fun and Games and LLCs: In re Stacey Friedrich

Fun and Games and LLCs: In re Stacey Friedrich

       In a recent decision from a Bankruptcy Court in Wisconsin, the court considered and rejected efforts by the sole member of an LLC, through its dissolution, to change the nature of its assets and in so doing prevent a lender from exercising its rights.  In re: Stacey L. Friedrich, Case No. 19-13843-13, 2020 WL 2306532 (Bankr. W.D. Wisc. May 5, 2020).

        Friedrich was the sole member of Total Body Laser Center, LLC, it organized in Wisconsin. The LLC had entered into three loans with State Bank of Cross Plains (the “Bank”), which were secured by the LLCs assets and as well personally guaranteed by Friedrich. The LLC defaulted on the notes, and the Bank filed a lawsuit seeking the appointment of the state law receiver. On the day that motion was to be considered, Friedrich dissolved the LLC, purported to transfer to himself all of its assets and debts. Still, the receivership motion was heard, and the receiver was appointed. On that same day, Friedrich filed for personal bankruptcy under Chapter 13. The question being considered in this opinion is whether the LLCs assets were or were not part of Friedrich's bankruptcy estate. Another issue would be whether those liabilities, now personally assumed by Friedrich, would be characterized as secured or unsecured. In order to be eligible for Chapter 13 bankruptcy, Friedrich needed to fall within the scope of 11 U.S.C. § 109(e), which provides that: 

Only an individual with regular income that owes, on the date of the filing of the petition, noncontingent, liquidated, unsecured debts of less than $419,275 ... may be a debtor under Chapter 13 of this title. 2020 WL 2306532, *2.

The court framed the dispute as follows:

The Bank asserts it did not consent to the transfer of its collateral from the LLC to the Debtor. The Bank argues the LLC’s assets are not part of the Debtor’s bankruptcy estate as the Assignment is void and ineffective under Wisconsin law. The bank also argues that even if the Assignment was successful, the LLC’s assets do not qualify as part of the Debtor’s secured debt in his Chapter 13 case. In other words, the Assignment did not change the Debtor’s obligation to the Bank - flowing from the personal guarantee on the Notes - from an unsecured to a secured claim. As a result, the Bank believes it's unsecured claim against the Debtor stands at $620,121.97. Debtor counters that the Bank’s $621,121.97 claim is secured against the Debtor by virtue of the transfer of all of the LLC’s assets and liabilities to himself personally. Id., *1.

As to the question of whether the LLC’s assets became property of Friedrich and from there part of his bankruptcy estate, the court answered in the negative. While LLC property may be transferred by an instrument executed by a member of the LLC in its name (Wisc. Stat. § 183.0702(1)), a transfer may not be made if, consequent thereto, the LLC will be unable to pay its debts as they come due in the ordinary course of business. Id. § 183.0607(1)(a). Furthermore, in liquidation, the assets of an LLC must first be distributed to its creditors. Id. § 183.0905. From there the court observed: 

Here, it is clear the LLC was unable to pay its debts as they became due. The attempted transfer of all the LLC’s assets further impaired its ability to pay its debts to the Bank. The LLC’s attempted distribution of its assets occurred in violation of Wis. Stat. § 183.0607(1)(a). It also violated the established priority for distribution of assets under Wis. Stat. § 183.0905. During its wind-upstage, the LLC’s assets must have first been distributed to its creditors, such as the Bank, and not to its sole member, the Debtor. 2020 WL 2306532, *3.

Turning to the question of whether, when assumed by Friedrich, the LLC’s obligations to the bank remained secured (a hurdle with respect to whether he was eligible to file for Chapter 13 bankruptcy), the court again answered in the negative. Recall that, on an unsecured basis, Frederick had guaranteed the LLC’s Bank debt. As argued by the Bank: 

The Bank argues that even if the Assignment was valid, the transferred LLC assets do not qualify as part of a secured debt in the current Chapter 13 case because the Debtor now owns assets subject to the Bank’s liens. Mere title to the asset does not create secured debt. Put differently, the Debtor’s acquisition of assets did not convert the Bank’s position and status as an unsecured creditor in his case to that of a secured creditor. Id., *4.

Agreeing with the bank, and after reviewing the applicable provisions of the Uniform Commercial Code, the court observed: 

The LLC’s attempt to transfer the Bank’s collateral to the Debtor does not mean the Debtor has pledged assets to the Bank. The Assignment did not change the Debtor’s relationship with the Bank. Assuming the Assignment was valid, the Debtor - as the new owner of the LLC’s assets, now owns assets subject to the Bank’s liens. Id., *6.

Holding that Friedrich’s liability to the Bank under his unsecured guarantee of the LLC’s  debt is valued at $620,121.97, his unsecured debt exceeded the statutory limit of $419,275 as set by 11 U.S.C. § 109(e), and for that reason it was held that he could not seek relief under Chapter 13 of the Bankruptcy Code.

Control of a Single Member LLC: In re Thomas

Control of a Single Member LLC: In re Thomas

In a decision handed down in May, a Tennessee Bankruptcy Court considered who would have control of a single-member LLC whose sole owner was in bankruptcy.  In this instance it was held that the member’s bankruptcy filing conveyed both the economic and management rights of the member to the bankruptcy estate and the trustee.  In re Thomas, 2020 WL 2569993 (Bankr. W.D. Tenn. May 8, 2020).

This decision was rendered in response to a motion by the trustee for an order directing that both the economic and the management rights of the bankrupt be in the estate to the effect that the chapter 11 trustee is the only authorized representative of an LLC. The debtor was the sole member of the LLC, and the Tennessee LLC Act (as do most of the acts across the country) provides that a member is disassociated (i.e., ceases to be a member and ceases to have the right to participate in the LLC’s management) upon the member filing bankruptcy. Tenn. Code Ann. § 48-249-503(a)(7)(A); id. § 48-249-505(a)(1). The only management rights that are reserved are those to participate in the LLC’s winding up is the LLC is to be terminated. The conflict was framed by the Court as follows:

At issue … is the question of a trustee in bankruptcy’s governance rights with respect to a [LLC] wholly owned by a debtor before the commencement of a voluntary bankruptcy case. The Trustee argues that by virtue of the filing of the bankruptcy petition and his appointment as Trustee, he holds both the financial rights and governance rights that make up the membership interest in TI Properties. Ms. Thomas argues that the Trustee holds only the financial rights but not the governance rights. The Debtor insists that the filing of his bankruptcy petition did not constitute a transfer of his governance rights under Tennessee law. 2020 WL 2569993, *1.

Under the Tennessee LLC Act a “membership interest” includes both the “financial rights” and the “governance rights.”  Tenn. Code Ann. §§ 48-249-102(22), (11) and (13).  Absent contractually agreed to limitations upon doing so, the financial rights are freely transferable, but the transferee has no right to participate in the LLC’s management.  Tenn. Code Ann. § 48-249-507(b).

In reviewing the statute the court determined that in multi-member LLCs a member’s bankruptcy filing results in the transfer and therefore termination of the debtor’s governance rights, but not of the financial rights, citing In re Albright, 291 B.R. 538, n. 7 (Bankr. D. Colo. 2003). However, Thomas the court concluded that there must be something different when the subject LLC had as its sole member the person in bankruptcy:

[T]his case presents the question of governance rights when the sole member of a single-member limited liability company files a petition in bankruptcy. The Tennessee Revised Act appears to limit a trustee in bankruptcy to the exercise of only those governance rights needed to wind up the affairs of the limited liability company reserved to a member whose membership interest is terminated. The Tennessee Revised Act does not address the governance rights of a single-member limited liability company when the membership interest terminates as the result of the filing of a bankruptcy petition but the trustee in bankruptcy desires to continue the business of the LLC for the benefit of creditors of the bankruptcy estate. 2020 WL 2569993, *3.

The Trustee argued that the provision of the LLC Act stripping a member of governance rights consequent to filing for bankruptcy was an invalid ipso facto clause, and that the governance rights became property of the estate, exercisable by the trustee, just as are the financial rights. Thomas would argue that even if the financial rights became property of the estate, the non-transferable governance rights remain with the now bankrupt debtor who continues to be vested with the authority to manage the LLC.  The Court would hold that in a single-member LLC, a member’s bankruptcy petition results in the transfer (under § 541(a)(1) of the Bankruptcy Code) of all aspects of the membership interest, financial and governance, to the trustee. 

The Trustee is correct. Upon the filing of his bankruptcy petition, all the Debtor’s interests in property, both legal and equitable, became property of his bankruptcy estate. The Tennessee Revised Act defines the membership interest of a member in an LLC as personal property. As such, it became property of the bankruptcy estate upon the filing of the bankruptcy petition. The Tennessee Revised Act attempts to prevent this result by providing for the “termination” of a membership interest upon the filing of a petition in bankruptcy by a member. This result is preempted, however, by  section 541(c)(1)(B) of the Bankruptcy Code. 2020 WL 2569993, *37.

FYI, the debtor is identified as William Thomas, and in several cases the decision uses male pronouns in refereeing to the debtor.  There are however numerous references to the debtor with “Ms.” and “she.”

Validity of Bankruptcy Filing Upheld

Validity of Bankruptcy Filing Upheld

In a recent decision from the Bankruptcy Court for the Southern District of New York, the bankruptcy petition filed on behalf of a North Carolina organized LLC, that petition being authorized by the manager of the LLC, was affirmed. In re: The Northwest Company, Case No. 20-10990 (MEW), 2020 WL 2121269 (Bankr. S.D.N.Y. May 1, 2020).

The Northwest Company, LLC, organized in North Carolina, was a manager-managed LLC for which Ross Auerbach served as the manager. After he placed the company in bankruptcy, a member, Extreme Horse Limited, asserted that the bankruptcy petition was not properly authorized and that the case should be dismissed. Extreme Horse made essentially two arguments as to why the petition was invalid, namely (i) while the manager of a North Carolina LLC may act with respect to matters in the ordinary course, the manager could not act with respect to extraordinary matters such as filing a bankruptcy petition, and (ii) a bankruptcy filing constitutes effectively a transfer of all or substantially all of the LLCs assets, and under North Carolina law that transaction requires the unanimous approval of the members and that approval was here lacking. Both of these arguments were considered in detail and rejected by the Northwest Company Court.

With respect to the argument that the manager of the North Carolina organized LLC is restricted to acting to matters in the ordinary course, the court reviewed the statute, and found no such limitation. Rather:

The North Carolina statute says generally that the manager or managers have the authority to act for the entity. See N.C. Gen. Stat. § 57D-3-20(a). There is nothing in that section that limits a manager’s authority to matters done in the ordinary course of business. The North Carolina statute separately lists certain items that can only be done with the consent of all members, and I will review that in a moment. But otherwise the manager can act on behalf of the limited liability company as a matter of North Carolina law.  2020 WL 2121269, *1.

With respect to the second allegation, namely that the bankruptcy constituted a transfer of all or substantially all LLC assets, and under the North Carolina LLC act that requires the consent of all members, the court determined that the filing for bankruptcy is not a transfer of assets. Continuing this analysis, the court considered the creation of the bankruptcy estate and a significant number of opinions of various bankruptcy courts around the country and as well a variety of decisions with respect to on-site number of decisions interpreting the North Carolina LLC Act. After a careful exposition of those decisions, the Court concluded: 

Based on the language of the Bankruptcy Code, the Supreme Court’s decision in [NLRB v. Bildisco & Bildisco, 460 5U. S. 513 (1984)], and the many other authorities I have cited above, I hold that the contention that the mere filing of a Chapter 11 petition and the creation of a Chapter 11 estate automatically amounts to a transfer or a disposition of substantially all of the debt towards that property for purposes of other laws is simply wrong, particularly where the debtor continues as a debtor-in-possession and continues to exercise dominion and control over its businesses and properties. Id., *4.

Extreme Horse would also make something akin to a “substance over form” argument, alleging that the purpose of the bankruptcy filing “is to complete a sale of assets.” The court found, inter alia, that that question was not before it. Rather:

That the [bankruptcy] filing itself did not accomplish such a sale or transfer, and even if a sale is contemplated (or planned, or expected, or likely) it is not a foregone conclusion, and it is not an outcome that irrevocably follows from the bankruptcy filing itself. The issue before me is whether the filing was authorized. Whether the Debtor does or does not need unanimous consent in order to propose a sale is not an issue that is before me today. Id., *5.

Authority to File for Bankruptcy on Behalf of an LLC?

Authority to File for Bankruptcy on Behalf of an LLC?

      Peter Mahler, in his blog New York Business Divorce, recently posted a quite interesting piece addressing the question of who, within any particular LLC, has authority to on its behalf file for bankruptcy protection. In that posting, he reviewed primarily the decision rendered in Catalyst Lifestyles Sport Resort, LLC v. Sheppard, a decision from the Northern District of Indiana. In the course of that decision, there was reviewed and contrasted the decision rendered in In Re Mid-South Business Associates, LLC, a decision from the Northern District of Mississippi.

      That blog posting is titled Who Gets to Play the Bankruptcy Card Under Your LLC Agreement? HERE IS A LINK to that posting.

On Charging Orders, Bankruptcy, and the Scope of the Automatic Stay

On Charging Orders, Bankruptcy, and the Scope of the Automatic Stay

      In a recent decision out of Louisiana, the Federal District Court, sitting as the appellate court from a Bankruptcy Court, pointed out some important issues to be considered in connection with the bankruptcy of an individual member of an LLC and the scope of the automatic stay. In this instance, certain of those important matters had not been fully considered by the Bankruptcy Court. For that reason, remand was ordered. In the Matter of: Thomas Mack and Mary Susan Mack, Civ. Act. No. 17-3587, 2018 WL 1532979 (E.D. LA. March 29, 2018).

 

Consequent to some financial setbacks, Thomas Mack, along with certain others, was held liable to First Bank for some $400,000 plus attorneys’ fees and additional collection costs. Mack, in turn, was a member in two LLCs, but the only one relevant to the opinion was Matrix Hospitality Group, L.L.C. Therein, he held a 60% membership interest, and apparently it was only through Matrix that Mack had any income, specifically:

Mack is paid by Matrix in three ways: (1) a monthly salary as a 1099 employee; (2) a periodic disbursement of profits as a part-owner; and (3) a performance bonus paid in April by particular clients if Matrix is able to meet client-set goals.

Seeking to collect on the judgment debt of approximately $400,000, First Bank sought a charging order against Mack’s interest in Matrix. The charging order was awarded and served on the company, but it failed to respond in accordance with Louisiana procedure. In addition, Matrix made distributions to Mack after the charging order was served. When legal action was then initiated against Matrix, Mack (both Thomas and Mary Susan) filed for Chapter 11 bankruptcy. At that point, the value of First Bank’s judgment had increased to $789,212.85.

From there the chronology of what happened gets somewhat confusing. What is known is that, on January 31, 2017, First Bank moved for relief from the automatic stay. Ultimately that relief was denied.

The reason this is confusing is that when a member files for bankruptcy, and the LLC is not itself in bankruptcy, and activities of the LLC are not automatically subject to the automatic stay there is an exception to this rule when, in the presence of “unusual circumstances,” “there is such identity between the debtor and the third-party defendant at the debtor may be said to be the real party defendant and that a judgment against the third-party defendant will in effect be a judgment or finding against the debtor.” 2018 WL 1532979, *3. In those circumstances, the automatic stay may extend to a non-debtor, in this instance Matrix. In this instance, however,:

The Court is unable to evaluate the Bankruptcy Court’s decision in denying the modification of the scope [of the automatic stay] because the Bankruptcy Court never made a finding on whether the scope of the stay included Matrix. Although it is arguably implied that the Bankruptcy Court determined that it did because it denied First Bank’s motion for relief, neither party raised the issue and the Bankruptcy Court did not state on the record whether the automatic stay applies to Matrix. Further, the Bankruptcy Court held that First Bank had the burden to modify the automatic stay, but the appellees [i.e., Mack], the parties seeking to maintain the stay, actually had the burden. The Bankruptcy Court failed to apply the appropriate standard to determine if modifying the stay was appropriate. Because the Bankruptcy Court did not require the appellees to meet their burden, the factual record is not sufficiently developed for this Court to determine whether the circumstances justify the rare finding that the stay applies to non-debtors [i.e. Matrix].

Id. (bracketed language added).

So the matter will go back to the Bankruptcy Court to determine whether Matrix and Mack are of such unitary interests that First Bank cannot, outside of the bankruptcy proceedings, seek to enforce its judgment by means of a charging order.

Petition of LLC to File for Bankruptcy Rejected: No Authority to File

Petition of LLC to File for Bankruptcy Rejected: No Authority to File

 

      In the decision from earlier this year, a bankruptcy court in Mississippi considered whether there was appropriate authority to file a bankruptcy petition on behalf of an LLC.  Holding ultimately that a vote of the members was required to file for bankruptcy, in that there is been no member vote, the petition was rejected. In re: Mid-South Business Associates, LLC, ___ B.R. ___, 2016 WL 4717939 (N.D. Miss. March 30, 2016).

      At the relevant time, this LLC had four members.  Two of those members were designated the “managers” of the LLC; those two members held well in excess of a majority of the interests in the LLC.  For reasons that are not detailed in this decision, the two managers abandoned the LLC, and the two non-manager members stepped in to manage its affairs. There was never, however, any vote of the members or any other official action to endorse these changes.

 

      Ultimately, the two non-manager members would assert that the managers had, as members, abandoned their interests in the LLC.  Thereafter, they on the LLC's behalf filed a petition for re-organization in bankruptcy. At that juncture, the two majority members filed an objection to the bankruptcy petition, asserting there was no authority to make that filing.

 

      The bankruptcy court applied the Mississippi Limited Liability Company Act and this LLC’s operating agreement and determined that there was no authority to file the bankruptcy petition.

 

      As to the alleged abandonment of the LLC and the loss of member status, the court found there was no provision to that effect in the LLC Act or the operating agreement.  As such the manager/members remained members in the LLC.

 

      The court identified two independent bases for finding that the bankruptcy petition was not authorized. First, while the operating agreement vested authority over business operations in the managers, it identified certain actions that could not be undertaken without the approval of two-thirds of the members. While bankruptcy was not listed therein, it was held that:

 

The Operating Agreement vested the Managers with the sole right to manage the business operations of the Debtor as necessary in the ordinary course of business, subject to any restrictions found in the Act. The Operating Agreement lists certain situations which require a two-thirds majority vote of the membership interests. Although filing a bankruptcy petition is not an enumerated action explicitly requiring a two-thirds majority vote, it is well-settled that “a decision to file for bankruptcy protection is a decision outside the ordinary course of business, even for an entity in dissolution.” In re Avalon Hotel Partners, LLC, 302 B.R. 377, 379 (Bankr. D.Or.2003)(emphasis added). Accordingly, even the Managers were not authorized to file for bankruptcy protection without a membership vote, because doing so is not within the scope of their authority as Managers under the terms of the Operating Agreement.  2016 WL 4717939, *8.

 

On the same point, the decision later recited:

 

Furthermore, the filing of a bankruptcy petition on behalf of an LLC is an extraordinary action that would have required a two-thirds vote of the membership interests in the Debtor pursuant to the Operating Agreement. See In re Arkco Properties, Inc., 207 B.R. 624, 628 (Bankr. E.D. Ark. 1997)(collecting authority for the proposition that “a bankruptcy filing is a specific act requiring specific authorization.”). 2016 WL 4717939, *9.

 

      In addition, the court observed that a bankruptcy petition would transfer the LLC’s property to the bankruptcy estate. As the operating agreement required the approval of two-thirds of the members in order to transfer all of the LLC's property, and as there had been no vote of the members, the petition was invalid. 2016 WL 4717939, *9.

 

 

 

 

More on Beads & Steeds; Denial of Leave to File Amended Complaint Asserting Substantive Consolidation Affirmed

More on Beads & Steeds; Denial of Leave to File Amended Complaint Asserting Substantive Consolidation Affirmed

     In the latest development in Beads & Steeds (Spradlin v. Beads & Steeds Inns, LLC (In re Howland), Case No. 12-51251, Adv. No. 14-5019 (Bankr. E.D. Ky.), Judge Karen Caldwell of the Eastern District affirmed the prior determination that the trustee would not be allowed to amend the complaint.

      Initially, at least as relevant to this discussion, the bankruptcy court had denied an effort by the bankruptcy trustee to utilize either or both of insider reverse piercing or outsider reverse piercing as a method to bring additional parties into the action. This dismissal was based upon the rule that piercing the veil is a remedy, not a substantive action, and a remedy could not be applied to create liability ab initio. That aspect of the case was read previously reviewed; HERE is a link to that discussion. Still, at the time it rejected the insider/outsider reverse pierce theories, the bankruptcy court afforded the trustee the opportunity to file an amended complaint based upon the theory of substantive consolidation. However, when ultimately tendered, the bankruptcy court rejected the amended complaint, finding it to be deficient in alleging facts that would justify substantive consolidation. HERE is a link to my review of this decision.

      In an opinion rendered March 31, the District Court affirmed the ruling of the bankruptcy court denying the motion to amend the complaint and as well affirmed the grant of judgment on the pleadings in favor of the debtors.

Corporate Director’s Breach of Fiduciary Duty Not Dischargeable in Bankruptcy

Corporate Director’s Breach of Fiduciary Duty Not Dischargeable in Bankruptcy

      In a recent decision by Judge Fulton of the Bankruptcy Court, it was held that the damages owed by a former corporate officer arising out of the corporation’s claim against him for breach of fiduciary duty could not be discharged in his personal bankruptcy. Cornerstone Industries Corp. v. Kaufman (In re: Louis A. Kaufman), Case No. 14-34045, Adv. Proc. No. 15-03011, __B.R. __, 2015 WL 4692569 (Bankr. W.D. Ky. Aug. 6, 2015).

      Kaufman, while serving apparently as an officer/director, of Cornerstone, violated his fiduciary duties thereto in assisting a former employee to compete with Cornerstone.  In that action, a judgment in the amount of $1,831,738.00 was entered in Cornerstone’s favor, which award included punitive damages.  After Kaufman's post-trial motions were denied, Kaufman filed for bankruptcy relief under Chapter 11 and sought to have the judgment in Cornerstone’s favor discharge.  This decision was in response to Cornerstone’s application for summary judgment to the effect that Kaufman's liability is not dischargeable.  That request for summary judgment would be granted.

      In response to the allegation that the debt should be dischargeable, the Court parsed the provisions of Sections 523(a)(2)(A) and 523(a)(6) of the Bankruptcy Code, they being certain of the provisions which set forth the test as to when a debt is not subject to discharge, and compared them to the findings in the state court action, including the specific terms utilized in the jury instructions.  Ultimately, the Court determined that the judgment against Kaufman was for conduct which falls within the exceptions from dischargeability as set forth in Section 523(a)(2)((A) and 523(a)(6), and for that reason discharge would be denied.

      In dicta, the Court also reviewed the test under Section 523(a)(4), but ultimately determined it needed to make no conclusion as to the application of that provision in that summary judgment was already justified under Sections 523(a)(2) and 523(a)(6).

      This case is a good demonstration of how counsel for the plaintiff, anticipating a ruling in their favor on breach of fiduciary duty, should carefully construct the jury instructions with an eye to avoiding dischargeability in the event the judgment-debtor subsequently seeks bankruptcy protection.

More on the Trustee’s Control of an LLC

More on the Trustee’s Control of an LLC

 

Following from my recent posting on the in re Lee decision, Prof. Joshua Fershee had provided comments at the Business Law Prof Blog. HERE IS A LINK to that discussion.

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.

  

A Few of the Consequences of a Member Bankruptcy

A Few of the Consequences of a Member Bankruptcy

Recently the Washington Court of Appeals addressed some of the consequences of a LLC’s member entering bankruptcy.  While different state laws may dictate different outcomes, in this case it was determined:

• Upon filing bankruptcy the member became an assignee and lost the ability to as a member initiate a derivate action on the LLC’s behalf;

 

• Neither 11 U.S.C. 541(c)(1) nor 11 U.S.C. 365, both ipso facto clauses of the bankruptcy code, serve to preempt the provision of the Oregon LLC Act to the effect that a member is dissociated from the LLC upon bankruptcy; and

 

• The bankruptcy estate will hold only the rights of the former members in the LLC’s economics and does not succeed to any right to participate in its management.

Northwest Wholesale, Inc. v. PAC Organic Fruit, LLC, 334 P.3d 63 (Wash. Ct. App. Div. 3 2012).

Both Yes and No to an LLC's Petition for Bankruptcy Protection

Both Yes and No to an LLC's Petition for Bankruptcy Protection

 

In a recent decision from the bankruptcy court for New Jersey, the ability of a particular LLC to file for bankruptcy protection was affirmed. At the same time, it was determined that the application lacked a legitimate basis. In re: Crest By The Sea, LLC, No.: 14-31681-ABA, 2014 WL 7366200 (Bankr.. N.J. December 23, 2014).

Initially , it should be noted that this decision, while making clear that the debtor was a limited liability company, the several times to the LLC as being "incorporated."  Clearly these statements are inaccurate.

 

The LLC originally had five members, but one of them declared bankruptcy.  At the time of filing of the bankruptcy petition, only three of the members had approved it.  It was open to debate whether the operating agreement allowed a simple majority of the members to approve the filing of a petition for bankruptcy, or whether unanimity was required.  The court indicated that a fair reading of the operating agreement was that only a majority vote of the members was required.  However, the court found that the post-filing approval of the bankruptcy petition by the last member was sufficient to give rise to unanimous approval if that was required.  Either way, the court did give effect to the provision of the New Jersey LLC act providing, inter alia, that a member is dissociated (i.e., lose of the right to participate in the LLC’s management) by reason of bankruptcy. 

 

Having determined that the bankruptcy petition was validly filed, the court then turned its attention to its intrinsic legitimacy.  In this instance, the court was able to determine that the bankruptcy petition was filed for the purpose of delaying certain state court actions and that no conceivable reorganization of the entity could take place.   Finding there to have been bad faith in the filing as evidenced by numerous errors in the petition and the related schedules, admission that it was filed in order to delay the state court proceedings and the failure of the signatory of the petition to appear at an evidenciary hearing:

[T]he court find that the Debtor abused the provisions, purpose and spirit of bankruptcy law in filing its bankruptcy petition. As such, the court has no choice but to dismiss the Debtor’s bankruptcy petition for cause under Section 70 (a) of the Bankruptcy Code.

Stripping Member of Management Rights in LLC After Bankruptcy Violated Automatic Stay

Stripping Member of Management Rights in LLC After Bankruptcy

Violated Automatic Stay

 

In a recent decision, it was held that stripping an LLC’s member of the right to vote in and control an LLC after bankruptcy violated the automatic stay.  This is an important decision as it responds to the question of whether or not the right to participate in management, as contrasted with the right to participate in the economics of the LLC, shall be deemed part of the bankruptcy estate.  Walro v. The Lee Group Holding Co., LLC (In re Lee), Case No. 12-90007-JJG-7A, Adv. Pro. No. 14-59011 (Bankr. S.D. Ind. Dec 18, 2014).

 

Lee held 51 of the 100 voting units in and therefore controlled The Lee Group Holding Company, LLC.  He held, however, no economic rights in the LLC.  After he filed for bankruptcty protection the trustee asserted that Lee’s “non-economic interest [in the voting rights] became property of the estate subject to control by the Trustee on the filing of the petition pursuant to 11 U.S.C. § 541.”  Slip op. at ¶ 9. The other members then executed a Resolution wherein they purported to accept Lee’s withdrawal as a member or the LLC – this removal was identified as being pursuant to section 3.7 of the operating agreement, but its language is not recited in the opinion.  They also purported to remove him as a manager and to elect a replacement manager.

 

The trustee brought this action challenging Lee’s removal as a member and manager of the LLC.

 

Curiously, the members defended their action on the basis that Lee was not really a member in that he did not share in the economics of the LLC, a notion that was quickly rejected by the court, it noting that the operating agreement referred to lee as a member.  The court also found that as Lee held a majority of the voting rights in the LLC it was not possible for the other members to alter the terms of the operating agreement.

 

The opinion did not reference the section of the LLC Act providing, inter alia, that a member is disassociated (and loses their voting rights) upon bankruptcy.  Likely the other members did not rely upon that provision in light of the many decisions that have found such statutes to violate the Bankruptcy Code’s prohibitions on ipso facto clauses.

 

Ultimately, Lee was not removed as a member and he remains the manager of the LLC; the actions of the other members purporting a different outcome violated the automatic stay and were void.

Bankruptcy Court Holds Trustee May Not Put the Cart Before the Horse and Strikes Down Effort to Pierce the Veil as a Cause Of Action

Bankruptcy Court Holds Trustee May Not Put the Cart Before the Horse

and Strikes Down Effort to Pierce the Veil as a Cause Of Action

      In a recent bankruptcy court decision, the Court rejected the effort by a bankruptcy trustee to utilize the concepts of “piercing the veil” in order to, ab initio, bring a third-party defendant into the action.  Rather, the Court held that piercing is a remedy, not a cause of action. Spradlin v. Beads and Steeds Inns, LLC (In re Howland), Case No. 12-51251, Adv. No. 14-5019, 2014 WL 4199637, __ B.R. __ (Aug. 22, 2014).

      The facts of this case are recited in the opinion as follows:

The following facts alleged in the Trustee’s Complaint are taken as true for the purpose of this decision.  On or about June 19, 2007, the Debtors formed Meadow Lake Horse Park, LLC (“Meadow Lake”).  On July 20, 2007, Meadow Lake purchased 133 acres of real estate in Garrard County known as 9863 Lexington Road, Lancaster, Kentucky (“Farm”) for $1,600,000 with the proceeds of a mortgage loan from United Bank & Trust Company (“United Bank”).  In late November 2010, the Debtors made a $760,000.00 payment on the mortgage loan to United Bank out of their personal income tax returns.  The Trustee asserts this payment was without consideration. 

On December 28, 2010, Meadow Lake sold the Farm for $800,000 to the Defendant Beads and Steeds Inns, LLC, which is wholly owned by Robert and Susan Hale (“2010 Transfer”).  The Defendant was formed shortly before the 2010 Transfer for the sole purpose of purchasing the Farm.  Defendant financed the full purchase price with a Mortgage Loan from United Bank in the amount of $800,000.

Subsequent to the sale of the Farm, Meadow Lake leased the Farm to the Defendant for $1,000 per month.  Meadow Lake also agreed to pay all insurance and real property taxes.  The Debtors operating the Farm as a horse boarding and training facility and a bed & breakfast and event facility both before and after the 2010 Transfer.

The Debtors filed Chapter 7 Bankruptcy on May 8, 2012.  The Debtors scheduled their interest in Meadow Lake on Schedule B and listed the value as $0.  Phaedra Spradlin was appointed Chapter 7 Trustee.

On May 6, 2014, the Trustee filed the underlying adversary proceeding seeking to avoid the 2010 Transfer as a fraudulent conveyance pursuant to § 548(a)(i)(B).  The Trustee also seeks to avoid the 2010 Transfer pursuant to KRS § 378.020 through § 544(b).  The Trustee further requests that the Bankruptcy Court disallow any claims by the Defendant pursuant to § 502(d).

      Essentially, while the bankruptcy filing was on behalf of the Matthew and Megan Howland, the Bankruptcy Trustee sought to allege that their LLC, Meadow Lake, had engaged in a fraudulent transfer which should be undone, it being posited that they (the Howlands and their LLC) should be treated as one and the same and the LLC “reverse pierced.”

      Although not cited by the Court, a member of an LLC has no ownership interest in the LLC’s property.  See KRS § 275.240(1); id. § 275.250.

      Reverse piercing is a twist on the traditional concept of piercing the “corporate” veil.  In traditional piercing, the plaintiff holding a judgment against a corporation that cannot be satisfied out of corporate assets seeks to “pierce” the corporation and hold the shareholders liable for the corporation’s debt.  In a reverse pierce, a claimant against the individual shareholders (in this case the members of the LLC) aims to access the assets held by the business entity and treat them as if owned directly by the shareholder/member.  Reverse piercing is in turn divided into two categories.  “Outsider” reverse piercing involves a claimant against the shareholder/member.  “Insider” reverse piercing involves the shareholder of the corporation or member of the LLC seeking to claim, for personal benefit, the assets of the LLC.

     After noting, consequent to the unique position of a Trustee, that this effort could be characterized as either outsider or insider reverse piercing, the court determined that categorization to not be necessary in that neither effort would be permitted to proceed.  Initially, relying on Turner v. Andrew (that decision is reviewed HERE) and Williams v. Oates (that decision is reviewed HERE), the Bankruptcy Court acknowledged that it is unclear whether a Kentucky court would accept the validity of reverse veil piercing.  That controversy did not, however, need to be addressed by the Bankruptcy Court in that it held that piercing could not be used in the affirmative approach sought by the Bankruptcy Trustee.  Rather, the court focused upon the fact that, under Kentucky’s piercing law, whatever it might be, piercing is a remedy and not itself a cause of action.  In that the Trustee sought to use reverse piercing as a theory for imposing the initial liability, rather than as a remedy by which to seek collection on primary liability, the effort was dismissed.  Specifically:

The Trustee argues that disregard of the corporate form of Meadow Lake [it was actually an LLC] would mean the 2010 Transfer is treated as if it were made by the Debtors directly.  Under this theory, it does not matter whether the Debtors or Meadow Lake committed the alleged wrongdoing.  The assets and liabilities of both parties are treated as merged both prospectively and retroactively.  This logic is not consistent with veil piercing as a remedy in Kentucky. 

Still, Beads and Steeds Inns, LLC is not off the hook.  The Bankruptcy Court afforded the Trustee the opportunity to file an amended complaint setting forth a traditional substantive consolidation claim.

Waiver of Member’s Dissociation by Reason of Bankruptcy

Waiver of Member’s Dissociation by Reason of Bankruptcy

     It is a standard provision in LLC Acts that a member’s bankruptcy dissociates that member, converting them into a mere assignee with no right to participate in management.  See, e.g., KRS §§ 275.280(1)(d), (e); Wa. Stat. §§ 25.15.130(1)(d), (e).  A member so dissociated, now an assignee, may be readmitted to member status by a vote of the incumbent members.  See, e.g., KRS § 275.275(1)(d); Wa. Stat. § 25.15.260(1).  A recent decision of a Washington state bankruptcy court determined that a member’s dissociation by reason of bankruptcy was waived.

     Charles McSwain was a member in Hawks Prairie Casino, LLC, a Washington limited liability company.  McSwain and his wife filed for bankruptcy under Chapter 11, listing their interest in Hawks Prairie as personal property.  The McSwains’ Plan of Reorganization provided:

Confirmation of the Plan shall automatically reinstate all of the debtors’ legal, equitable and other rights and Interests as existing immediately prior to the Petition Date with respect to Debtors’ interest in … Hawks Prairie Casino, LLC.

     Hawks Prairie objected to the Plan on the grounds that it was inconsistent with its operating agreement and the Washington LLC Act and “would impermissibly reinstate McSwain as a member with full management rights.”

     The Court, in what was ultimately dicta, engaged in an analysis of whether the operating agreement of Hawks Prairie was or was not an executory agreement, indicating that it satisfied two of the applicable elements of that analysis as employed in the Ninth Circuit, but then leaving the third element unaddressed as it moved to separate the basis of its holding. 

     Ultimately the Court concluded that there had been an implicit waiver of McSwain’s bankruptcy and the resultant dissociation.  Norberg had testified that she knew “from the very beginning” of the bankruptcy proceeding that by operation of law McSwain was an assignee.  However, even after his bankruptcy filing:

McSwain continued to be fully involved in all activity of Hawks Prairie and its management and Norberg treated him as a full member until May 22, 2009.  Norberg, as President of Hawks Prairie allowed McSwain to participate fully in managing the company and exercise all membership rights, including the right to vote.  Slip op. at 7.

     In at least one instance, McSwain’s vote in favor of a transaction was a condition precedent to the company having engaged in the transaction, an insufficient number of other members having voted in favor thereof. 

     The Court found that Norberg, having permitted McSwain to participate in management after his bankruptcy, waived the right to treat him as an assignee.  Having treated him as a full member in the face of knowledge that it was entitled to treat him as an assignee, the right to enforce the statutory and contractual consequences of bankruptcy were waived.  Consequent thereto:

Under Washington law and the Hawks Prairie Operating Agreement, McSwain is entitled to exercise his full management and membership rights in Hawks Prairie Casino, LLC.

Dissociation from LLC upon Bankruptcy Violates Ipso Facto

Dissociation from LLC upon Bankruptcy Violates Ipso Facto (So says one Court)

     In In re: Dixie Management & Investment, Limited Partners, No. 5-08-6K-73874 (Bankr. W.D.Ark. May 9, 2011), the Court addressed whether the limited partnership, upon its chapter 11 filing, was dissociated as a member from Moberly Investment Group, LLC (“MIG”).  MIG’s operating agreement and the Arkansas statute (§ 4-32-802(a)(4)(B)) provide for dissociation upon bankruptcy.  Dixie was a 62% member in MIG.

     Responding to the assertion of automatic dissociation upon bankruptcy, Dixie argued the operating agreement is an executory contract and that dissociation violated the Bankr. Code § 365(e)(1) ipso facto clause.  Even if not executory, Dixie continued, dissociation would violate the Bankr. Code § 541(c)(1) ipso facto clause.

     Focusing upon § 541 (no evidence having been presented as to whether or not the operating agreement was executory under the Countryman test), the Court observed that Dixie’s interest in MIG became property of Dixie’s bankruptcy estate.  Rejecting automatic dissociation, the Court wrote:

Under § 541(c)(1), Dixie’s membership in MIG continues to exist and constitutes property of the estate, despite the conflicting provisions in the [operating agreement] and contrary state law.

The Court holds that the [operating agreement] language regarding the alleged dissociation of a member based on the filing of its bankruptcy petition is in contravention of the bankruptcy code, specifically § 541(c)(1), and, therefore, is ineffective….  Further, under § 363(l), Dixie is permitted the use and benefit of its interest in the LLC and has the right to continue as a member of the LLC.