NCBJ Report: What is a Limited Liability Company and Why Does It Matter in Bankruptcy?

This panel discussed some of the unusual issues raised by limited liability companies.   The panel consisted of Bankruptcy Judge Ashely Chan from the Eastern District of Pennsylvania,  Prof. Carter Bishop from Suffolk University Law School, Craig Goldblatt form Wilmer Hale, Paul L. Lion, III from Morrison & Foerster, LLP and Emily Pagorski from Stoll Keenon Ogden PLLC   Emily Pagorski and Craig Goldblatt played the role of litigators in two moot court arguments.

What Is It?

According to Paul "Chip" Lion, a limited liability company is neither a corporation nor a partnership. LLCs have members rather than shareholders.  They have managers who may be members who run the business.    LLC's are formed by filing a certificate of formation.   They are governed by their operating agreement.    The state where the certificate of formation governs the legal affairs of the LLC.

The members of an LLC own interests, which consist of economic interests, information rights and management rights.    Managers of an LLC owe fiduciary duties to the LLC    These are duties of loyalty and care and can be modified under the law of some states.

Bankruptcy Remote Entities

Prof. Bishop introduced the problem of an LLC being used as a bankruptcy remote entity.   Under the hypothetical, unanimous consent was required to file bankruptcy and allowed members to act in its own interest and waived all duties except for the implied duty of good faith and fair dealing.  The operating agreement was then modified to add a non-economic member to presumably represent the interest of the secured creditor.    When it is time to file bankruptcy, the members disagree.   However, the LLC files anyway.    The secured creditor then sought to dismiss the case as a bad faith filing.

Two cases involving LLCs have found that bankruptcy policy invalidated the state law blocking provision because the non-economic member did not have a duty to act in the entity's best interest.  In re Lake Michigan Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. ND Ill. 2016); In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016)  However, a case involving a limited partnership reached the opposite conclusion.   In re Squire Partners, Limited, 2017 W.L. 2901334 (E.D. Ark. 2017), appeal filed to Eighth Circuit.   The Squire case relied on the fact that the partner with the blocking interest had a financial interest.

The hypothetical posed a conflict between the ability of parties to contract as allowed by state law as opposed to whether the contractual provision was a waiver of the right to file bankruptcy similar to a pre-petition waiver of discharge.  After a mock trial, the court found that the non-economic member did not act in good faith and that therefore his blocking vote was invalid.   In partcular, under the hypothetical, the debtor had equity which would be lost in the event of a foreclosure.

Is an Operating Agreement an Executory Contract?

In the second hypothetical, a member holds the right to manage the LLC.    There are other members.   Under the Operating Agreement, the right to manage cannot be assigned.  Additionally, the Operating Agreement provides that upon filing bankruptcy, the member ceases to be a member.   When the managing member files bankruptcy, the Chapter 7 trustee attempts to assume the operating agreement and dissolve the LLC over the objection of the other members.  The hypothetical was based on a California LLC.

Prof. Bishop argued that under Sec. 541 would bring the economic interest and management right into the estate.   Most Operating Agreements would not meet the Countryman test for an executory contract.   Additionally, Sec. 365 precludes the assumption of a personal services contract.    Further, the contract would be subject to the ipso facto clause of Sec. 365.  

The hypothetical posed a conflict between the property of the estate provisions of Sec. 541 and the executory contract provisions of Sec. 365.   The judge asked whether it would be appropriate to apply a broader definition of an executory contract than the Countryman test.    The hypothetical also raised the issue of how the Chapter 7 trustee could meet the debtor's fiduciary duties to the other members.     The Court ruled that both the economic and non-economic interests entered the estate but that the Trustee would order the Trustee to wait six months before dissolving the LLC to maximize the value for the other members.

One issue that was not raised by the discussion was the application of 11 U.S.C. Sec. 541(b)(1) which states that property of the estate does not include a power that the debtor may only exercise for the benefit of an entity other than the debtor.   In my opinion, the right to manage an LLC is a power which the member exercises for the benefit of the LLC and the other members.   Thus, I would expect that it would not be property of the estate.

I liked the format of this program because it used two of the panel members to provide background and introduce the hypotheticals while the two litigator members of the panel argued the case to an actual Bankruptcy Judge.