The trustee in the bankruptcy of an LLC member asked the Bankruptcy Court for a declaration that the LLC was dissolved pursuant to its operating agreement. The operating agreement mandated dissolution upon the bankruptcy of a member, but the court denied the trustee’s motion, relying on provisions in the Bankruptcy Act that trump contractual limitations. In re Warner, 480 B.R. 641 (Bankr. N.D. W.Va. Sept. 27, 2012). The ruling left the trustee with limited options for liquidating the member’s LLC interest and realizing value for the member’s creditors.
Background. Benjamin Warner was one of several members of McCoy Farm, LLC, a West Virginia limited liability company formed in 2002. The LLC owned a 141-acre real estate parcel that included a family lodge and a farm house.
In April 2010 Warner filed a Chapter 7 bankruptcy petition. In 2011 the bankruptcy trustee asked the other members to agree to dissolve and liquidate the LLC, but they declined his request. The trustee then filed a motion, asking the Bankruptcy Court for a declaration that the LLC was dissolved.
The LLC’s operating agreement was clear: it specified that the LLC “shall be dissolved upon the occurrence of any of the following events: … (ii) upon the death, retirement, withdrawal, expulsion, bankruptcy or dissolution of a Member.” Id. at 646. Warner’s bankruptcy thus triggered the LLC’s dissolution. The agreement allowed for an exception, though, “if the remaining Members unanimously agree to continue the Company under this Agreement within sixty (60) days of such dissolution.” Id. at 647. The members desired to avoid dissolution and accordingly passed a two-part resolution that continued the LLC, and also dissociated Warner and provided that he would have no right to participate in the business of the LLC.
Court’s Analysis. The court found both components of the members’ resolution to be invalid. The attempt to continue the LLC failed because the members’ resolution was at least ten days too late and therefore outside the 60-day window permitted by the operating agreement. Id. at 648. The attempt to dissociate Warner violated the automatic stay of Warner’s bankruptcy filing and therefore was invalid. Id. at 647. (Bankruptcy’s automatic stay gives the debtor a breathing spell from creditors by barring actions such as initiating or continuing lawsuits against the debtor, actions to obtain the debtor’s property, and creating or enforcing liens against a debtor’s property. 11 U.S.C. § 362(a).)
Executory Contract. The court then reached the core issue: whether dissolution of the LLC pursuant to the operating agreement would violate the Bankruptcy Act. The court first considered whether the LLC’s operating agreement was an executory contract under Section 365 of the Bankruptcy Act, “as the determination is essential to an evaluation of the Trustee’s rights and powers in McCoy Farm.” Id. at 648. For example, the trustee or debtor must assume or reject an executory contract.
“Executory contract” is not defined in the Bankruptcy Act and there is no consensus among the courts as to whether LLC agreements are considered executory contracts. The McCoy Farm agreement therefore had to be individually assessed to determine if it should be considered an executory contract. Id. at 651. Because Warner was not a manager of McCoy Farm, had no obligation to contribute capital to the LLC or to perform services for the LLC, and could withdraw from the LLC at any time, the court found that he had no unperformed material obligations. The operating agreement was therefore not an executory contract and Section 365 did not apply. Id. at 652.
Section 541. Section 541 of the Bankruptcy Act sweeps into the bankruptcy estate all of the debtor’s legal and equitable interests in the debtor’s property. 11 U.S.C. § 541. After reviewing West Virginia’s Uniform Limited Liability Company Act and the LLC’s operating agreement, the court concluded that Warner’s economic rights (rights to distributions from the LLC) and his non-economic rights (the right to vote as a member and to participate in the affairs of the LLC) became part of the bankruptcy estate. In re Warner, 480 B.R. at 653.
Section 541 also requires that the debtor’s property become property of the bankruptcy estate notwithstanding any provision in an agreement or applicable nonbankruptcy law that (1) is conditioned on the insolvency of the debtor and (2) forfeits, modifies or terminates the debtor’s interest in the property. 11 U.S.C. § 541(c). The purpose of § 541(c) is to eliminate barriers to the transfer of property into the bankruptcy estate, not to invalidate restrictions on the transfer of property from the trustee to third parties. In re Warner, 480 B.R. at 649 n.5.
The court found that the operating agreement’s dissolution requirement fell within the prohibition of § 541(c):
Absent application of § 541(c)(1), the Debtor’s bankruptcy filing would modify the nature of his interest in McCoy Farm: Prior to his bankruptcy he held the full array of economic and non-economic rights provided under the Operating Agreement in a viable, operating company; while after his bankruptcy, he held an economic interest in a defunct LLC and constrained non-economic rights.
Id. at 655 (footnotes omitted). The court accordingly held that § 541(c)(1) invalidated the operating agreement’s dissolution of the LLC.
The trustee argued that automatic preemption of the LLC dissolution provisions would destroy value for creditors of the estate and leave the trustee with few avenues to realize value for the estate, and that he should both stand in the shoes of the debtor and also have the expanded rights the bankruptcy estate acquired under § 541(c). In short, the trustee argued that he should have the discretion to opt in or out of the dissolution provisions of the operating agreement.
The court rejected that argument because it would expand the trustee’s rights beyond those held by the debtor, and concluded by denying the trustee’s motion. Id. at 656, 658. The trustee was therefore unable to enforce the LLC agreement’s dissolution of the LLC.
Comment. The court’s ruling leaves the trustee in a pretty pickle. Warner’s one-sixth interest in the LLC, which owns a large parcel of real estate, may be very valuable if the LLC has little or no debt. But with no ability to force a dissolution, the trustee may be unable to access that value. The court recognized the trustee’s dilemma: “The court acknowledges that a trustee holding a debtor’s interest in a LLC is in a knotty position to realize value for the estate.” Id. at 657.
The court suggested that the trustee might have other methods of liquidating Warner’s member interest. For example, said the court, the trustee has Warner’s membership rights and might exercise the right to seek judicial dissolution. But in West Virginia, as in most states, the grounds for a judicial decree of dissolution are fairly limited. There must be substantial frustration of the LLC’s purpose or wrongdoing by the manager or the managing members, or it must be not reasonably practicable to carry on the LLC’s business in conformity with the operating agreement. W. Va. Code § 31B-8-801. The court’s recital of the facts in Warner did not suggest that any of those grounds were applicable.