by John C. Murray
© 2003. All rights reserved.
The efficacy of a single-member limited liability company ("LLC") as an asset-protection vehicle has been thrown into doubt by a Colorado bankruptcy-court decision. In In re Ashley Albright, 291 B.R. 538 (Bankr. D. Colo. 2003), the debtor, who filed a Chapter 13 bankruptcy petition that was later converted to a Chapter 7 liquidation, was the sole member and manager of a Colorado LLC at the time of the filing. The LLC was not a debtor in bankruptcy. The Chapter 7 trustee contended that because the debtor was the sole member and manager at the time the debtor filed bankruptcy, the trustee now controlled the LLC and could therefore sell the real property owned by the LLC and distribute the net sales proceeds to the bankruptcy estate. The debtor argued that the trustee acted only for the debtor's creditors and at most was entitled to a statutory charging order (against distributions made on account of the debtor's LLC membership interest) and could not assume management of the LLC or sell its property. The court referred to the Colorado LLC statute, under which the debtor's membership interest constituted the personal property of the member. According to the court, "[b]ecause there are no other members in the LLC, the entire membership interest passed to the bankruptcy estate, and the trustee became a 'substituted member.'" Id. at 540. The court also stated that, "upon the Debtor's bankruptcy filing, the Trustee now controls, directly or indirectly, all governance of that entity, including decisions regarding liquidation of the entity's assets." Id. at 541. The court reasoned that because there were no other members in the LLC, no written unanimous approval of the transfer was necessary, as would be the case under Colorado law if there were other members - no matter how small such other membership interests may be.
Colorado's LLC statute, similar to those in other states, provides that if the unanimous consent of all members in a multi-member LLC is not obtained, the bankruptcy estate is only entitled to receive the bankrupt member's share of the profits or other compensation that the bankrupt member was otherwise entitled to, and would not be entitled to any role in the voting or governance of the LLC. However, in a footnote the court stated that this statutory limitation "does not create an asset shelter for clever debtors. To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with 'peppercorn' co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse." Id. at n.9. The court rejected the debtor's assertion that the trustee should be entitled only to a charging order, finding that a charging order existed only to protect other members of an LLC, and in a single-member LLC there were no non-debtor members to protect. The court ruled that the trustee, as the sole member of the LLC, therefore controlled the LLC and could cause the LLC to sell its property and distribute the net proceeds to the bankruptcy estate, or alternatively the trustee could elect to distribute the LLC's property to the bankruptcy estate and then liquidate the property himself. However, the court did permit the debtor to make a claim for her post-petition mortgage payments to preserve the real property of the LLC, which was now an asset of the bankruptcy estate. See also Associates Commercial Corp. v. Rodio (In re Rodeo), 257 B.R. 699m 701 (Bankr. D. Conn. 2001) (property belonging to limited liability company itself is not part of the bankruptcy estate of bankrupt member); 805 ILCS 180/30-1(a) (2002); ("A member is not a co-owner of, and has no transferable interest in, property of a limited liability company.")
Comments:
1) Under most state LLC statutes, if a member files a bankruptcy case the LLC automatically dissolves (unless otherwise specified in the operating agreement). Is this provision of a state LLC statute overridden by the Bankruptcy Code because it constitutes an ipso facto clause (i.e., a clause that modifies or eliminates a party's contractual rights solely because of a bankruptcy filing) which is unenforceable under sections 541(c)(1), 363(l) and 365(e) of the Bankruptcy Code? The answer may depend on whether the articles of organization and operating agreement are regarded as executory contracts (i.e., contracts on which performance remains due to some extent on both sides). The question then becomes whether these documents are "organic" governing documents (as opposed to executory contracts) and whether a bankruptcy court, even if it held the documents to be executory, would enforce the documents with the sole exception of the bankruptcy-remote provisions if the agreements were rejected, or permit such rejection to cause a dissolution of the LLC without providing at least a "winding down" period.
2) There are no specific provisions in the Bankruptcy Code ("Code") or Bankruptcy Rules that deal with LLCs, and the application of bankruptcy law and specific Code provisions is uncertain. Because LLCs are still relatively new state-law creations, the treatment of these entities in bankruptcy is uncertain, i.e., will they be treated as partnerships or corporations for bankruptcy purposes? See In re ICLNDS Notes Acquisition, LLC, 259 B.R. 289, 292 (Bankr. N.D. Ohio 2001) ("an LLC is neither a corporation or a partnership, as those terms are commonly understood. Instead, an LLC is a hybrid"). This uncertainty is especially troublesome with respect to single-member LLCs. This is because if an LLC is treated as a partnership, it could dissolve upon the bankruptcy of its sole member and its assets distributed to creditors and the bankrupt member (or, as in the Albright case, to the trustee of the bankruptcy estate). If, on the other hand, the LLC were treated as a corporation, it would not dissolve upon the bankruptcy of the last remaining member, although the member's ownership interest could be transferred. Some commentators believe that, at least under the Delaware Limited Liability Company Act ("DLLC Act"), an LLC should be treated as a corporation because the LLC operating agreement is similar to a certificate of incorporation and a member's interest is analogous to a share of stock in a corporation. See Larry E. Ribstein and Robert R. Keatings, Limited Liability Companies, § 14.04, at 14-18 (2000) ("[F]rom a policy standpoint, LLCs probably should be considered corporations for bankruptcy purposes because the special bankruptcy provisions that apply to partnerships primarily relate to the general partner's duty to contribute to payment of the firm's debts"); Carter G. Bishop and Daniel S. Kleinberger, Limited Liability Companies Tax and Business Law, 1.04 (2)(a) (1999).
3) Many states have amended their LLC statutes to specifically permit the formation of single-member LLCs. Since 1998, single-member LLCs have become very popular in securitized and structured-financing transactions because of their tax advantages, flexibility and low transaction costs. However, there is a question as to whether a single-member LLC will continue to exist upon the sole member's bankruptcy, death, or dissolution. There is very little legal precedent or case law on this issue. The governing law must be consulted to see if it allows for the continued existence of the LLC after the sole member's bankruptcy or dissolution. For example, the DLLC Act (under which many LLCs are formed because of the favorable statutory framework) specifically provides for the LLC's continued existence under such circumstances, unless otherwise provided in the operating agreement. See Del. Code Ann. tit. 6, § 18-801 (a)(4). The DLLC Act also provides that by default an LLC's existence is perpetual. Del. Code Ann. tit. 6, § 18-801 (a) (1). A single-member LLC, whose only member is the entity or individual in question, requires the creation of only one entity, the LLC itself. See Larry E. Ribstein and Robert R. Keating, Ribstein and Keating on Limited Liability Companies, Ch. 4, p.3 (1996) (Fall 2001 Update).
4) Bankruptcy courts generally look to state law to determine whether dissolution occurs upon the bankruptcy of the sole member of a single-member LLC. Under the DLLC Act, for example, an LLC whose member is in bankruptcy would be treated as if it were a corporation with a bankrupt shareholder and the bankruptcy would not cause a dissolution. If a Delaware LLC agreement is properly drafted, under Delaware law even the bankruptcy of the last remaining member will not, by itself, cause the dissolution of the LLC. Furthermore, under the DLLC Act, it is permissible to admit "springing members," i.e., a person may be admitted as a member (including as the sole member) without acquiring an interest in the LLC or being required to make a capital contribution. See Del. Code Ann. tit. 6, §§ 18-801(a)(4) and (b); James G. Leyden Jr., A Key State's Approach to LLCs: Delaware Can Be Different, 9-MAY Bus. L. Today 51, 63 (2000).
5) The single-member LLC operating agreement should specifically provide for the continued existence of the LLC upon the sole member's dissolution or the termination of its membership in the LLC. The operating agreement should also condition the sole member's right to withdraw on the existence of a succeeding member (or "springing" member) who would be capable of continuing the operations and existence of the LLC. Typical "bankruptcy remote" provisions, which are promulgated by rating agencies and appear in almost all LLC formative documents involving securitized loan transactions, also would be applicable with respect to single-member LLCs. Legal opinions as to the bankruptcy remoteness of the borrowing entity (and perhaps its principals) are also usually also required by the rating agencies, such as Moody's, Fitch, and Standard & Poor's, in connection with securitized financing transactions to provide support for a high rating. This is especially so in connection with a single-member LLC, where the bankruptcy treatment of such a vehicle is less clear. The enforceability of choice-of-law provisions in LLC documents is also extremely important, because the ability of a single-member LLC to continue in existence after the departure of the sole member is often dependent on state law that enables the single-member LLC to continue in existence.
6) The DLLC Act also specifically provides for the exercise of a deceased or terminated member's rights by a personal representative. Del. Code Ann. tit. 6, § 18-705. The DLLC Act also provides for termination of an LLC without members, but contains a mechanism to prevent the winding up the LLC. The DLLC Act permits the admission of a personal representative of the departed member within 90 days after such departure, if the representative agrees in writing to be admitted or such representative is admitted pursuant to a provision in the LLC agreement providing for such admission on the departure of a member. See Del. Code Ann. tit. 6, § 18-801(a)(4).
7) It has been suggested that the single-member LLC operating agreement provide (where permitted) that a board of managers, containing at least two "independent" members, would govern certain management and operating decisions. The operating agreement would provide that no bankruptcy filing or related action could occur without the unanimous consent of all the board members. See Alexander Dill, Yaron Ernst, Michael Kanef, and Adam Toft, Handle With Care: Single Member LLCs in Structured Transactions, Special Report, Moody's Investor Services, March 19, 1999. However, if the outside managers are not truly independent and do not perform their fiduciary duty to the entity (and to all creditors, including unsecured creditors), as opposed to specific third-party creditors, the goal of bankruptcy-remoteness may not be achieved. However, the inclusion of such a "bankruptcy remote provision" in an LLC operating agreement, especially one that requires approval of certain entity actions by an independent director who is in actuality under the influence of a major secured lender, may later be determined by a bankruptcy court to run afoul of the Code's prohibition of provisions preventing an entity from commencing a bankruptcy reorganization. Also, several courts have held that as an entity approaches insolvency, i.e., becomes unable to pay its debts as they become due in the ordinary course of business, the directors owe a fiduciary duty to all the creditors of the company. See, e.g., In In re Kingston Square Associates, 214 B.R. 713, 735 (Bankr. S.D.N.Y. 1997). In this case, the debtor was unable to obtain its board of directors' permission to file a voluntary bankruptcy proceeding because of the refusal of the "independent director" to authorize such a filing. The debtor then orchestrated an involuntary filing by certain unsecured creditors (with the help of the debtor's limited partners). The bankruptcy court found that such actions were not taken in bad faith and that the debtor reasonably believed that the best course of action for the entity was to file bankruptcy. The court further held that such actions were necessary because the "independent director" had abdicated his fiduciary duty to the debtors, creditors and limited partners in favor of the interests of the mortgage lender. The court therefore refused to grant the secured creditor's motion to dismiss the involuntary filing. The court also appointed a Chapter 11 trustee, and held that the debtor's board of directors had violated their fiduciary duties owed to the debtor, its limited partners and its unsecured creditors and interest holders, in favor of the interests of the mortgage lender. The court declined, however, to specifically nullify the debtor corporation's bylaw provision containing the bankruptcy-proof provisions as against public policy.
8) Another proposed method of enhancing the bankruptcy-remoteness of a single-member LLC is to structure the entity so that the sole member is itself a single-purpose bankruptcy-remote entity. Unlike an individual, who can (and eventually will) die, the sole member of a single-member LLC that is itself structured as a single-asset bankruptcy-remote entity will have a perpetual existence. However, borrowers may resist the imposition of such a requirement because they lose some of the flexibility and cost-saving advantages, including direct personal ownership, of single-member LLCs.
