Should a membership agreement governing a debtor’s interest in an LLC be treated as property of the estate or an executory contract? Equally, should a debtor’s economic and non-economic interests in an LLC be treated as property or a contractual right? Can’t make up your mind? Don’t worry—the bankruptcy courts can’t either.
As discussed here and here it is not clear whether, in chapter 11, a debtor’s LLC membership agreement and the accompanying interest in the LLC should be treated as property or contractual rights. What is clear, however, is that inconsistent treatment of the LLC membership agreement and the accompanying interests in the LLC by bankruptcy courts has the great potential for diverging outcomes in chapter 11 cases. Consider, for instance, that when a court treats an LLC membership agreement and the accompanying interest in the LLC as property of the estate, provisions in the state statute governing the LLC that would otherwise divest the debtor of certain rights in the LLC solely because of the bankruptcy filing (commonly referred to as an “ipso facto” provision) would be preempted by section 541(c)(1) of the Bankruptcy Code, which preempts any applicable nonbankruptcy law from divesting a debtor of its interest in property solely because of the debtor’s insolvency or financial condition. By contrast, when a court treats an LLC membership agreement as an executory contract, it is less clear whether such an ipso factoprovision would be preempted by the Bankruptcy Code because section 365(c)(1)(A)preserves the enforceability of certain ipso facto provisions in executory contracts.
A recent decision from the Bankruptcy Court for the Middle District of Pennsylvania, Schwab v. Stroup (In re Stroup) provides us with another example of how the outcome of chapter 11 cases might diverge depending on whether a debtor’s interests in an LLC is treated as property of the estate or as a contractual right.
On February 13, 2014, Scott and Karen Stroup filed for chapter 7 (Valentine’s Day must have been extra special that year). The Stroups, along with three other members, each owned approximately 20% of an LLC located in Pennsylvania. The Stroups listed their membership interest in this LLC as part of their personal property. The chapter 7 trustee, by means of an adversary proceeding, moved for summary judgment to sell both the Stroups’ and the co-owners’ interest in the LLC under section 363(h) of the Bankruptcy Code and to distribute the proceeds from the sale of such property to the Stroups and the co-owners based on their respective interests.
Pursuant to section 363(h), a trustee may, among other things, sell the interest of any co-owner in the debtor’s property. A trustee is empowered to do so if, at the time of the commencement of the case, the debtor had an undivided interest in the property as a tenant in common, joint tenant, or tenant by the entirety and the trustee proves that (1) the partition of the property among the estate and the co-owners would be impracticable; (2) the sale of the estate’s undivided interest in such property would realize significantly less for the estate than sale of such property free of the interests of such co-owners; (3) the benefit to the estate of a sale of such property free of the interests of co-owners outweighs the detriment to such co-owners; and (4) the property is not used in, among other things, the production or distribution of electric energy or of natural or synthetic gas for heat, light, or power.
In his motion for summary judgment, the trustee stated that it was clear that the proposed sale satisfied the requirements under section 363(h). In opposition, however, the co-owners argued that genuine issues of material fact were outstanding, particularly with respect to whether the property could be subject to partition and whether the sale of the interests free and clear of the co-owners’ interest would realize significantly more value for the estate than the sale of only the Stroups’ undivided interests in the LLC.
Because these facts were presented to the court on a motion for summary judgment, the court assumed for the purposes of the analysis that the membership interest was personal property (without any consideration of whether the interest might be contractual), and accordingly, could be subject to a sale under section 363(h) if the requisite elements were met. In the result, however, the court denied the trustee’s motion for summary judgment agreeing that there was an outstanding issue of material fact (though, the court identified an outstanding issue of material fact that differed from those identified by the co-owners). The court determined that, before proving that the four requirements of section 363(h) were satisfied, the trustee needed to first produce sufficient evidence showing that the debtor had an undivided interest in the property as a tenant in common, joint tenant, or tenant by the entirety with the co-owners. Based on the evidence presented, the court held that the trustee failed to prove that the Stroups held their respective interests in the LLC with any of the co-owners in one of the types of ownerships required by section 363(h), and the court was not willing to speculate.
Section 363(h) applies only to the sale of the debtor’s property. Therefore, although the court dismissed the motion for summary judgment and did not make a determination of the nature of the Stroups’ membership interest in the LLC, this decision is notable because it suggests that, to the extent a membership interest in an LLC is considered property of the estate, and the governing agreements provide that the members hold “undivided interests” in the LLC as tenants in common, joint tenants, or tenants by the entirety, a debtor may be authorized to ride roughshod over the wishes of other LLC members and sell membership interests in an LLC. This is, in sum, yet another way that outcomes may diverge depending on whether a debtor’s interest in an LLC is considered to be the debtor’s property or contractual right.