The homestead exemption is important to the many debtors in bankruptcy who own their own homes. But what if the debtor owns the home through his or her single-member LLC? Is that good enough? A Bankruptcy Appellate Panel recently said no, ruling that a debtor whose home was owned by her single-member LLC could not take advantage of the homestead exemption. In re Breece, No. 12-8018, 2013 WL 197399 (B.A.P. 6th Cir. Jan. 18, 2013).
The homestead exemption prevents a debtor’s principal residence from being sold in the debtor’s bankruptcy to satisfy unsecured creditors. The amount of the exemption varies widely by state. If the debtor’s equity in the residence is more than the exemption’s limit, the residence may be sold but the debtor can then retain the exempt amount. In some states, most notoriously Florida, there is no dollar limit on the exemption.
The Facts. Monae Breece and her grandmother jointly purchased a home in Union Town, Ohio in 2004. Several months later they formed an Ohio LLC and transferred ownership of the home to their LLC. Breece’s grandmother subsequently died and Breece became the sole member of the LLC. The residence is subject to a mortgage, and Breece is personally liable for the debt secured by the mortgage. Breece has resided in the home since 2004.
In 2011 Breece filed a voluntary Chapter 7 bankruptcy and claimed a homestead exemption in her residence. The Trustee objected to Breece’s claimed homestead exemption on the basis that the property was owned by the LLC and not by Breece. The bankruptcy court disallowed the homestead exemption, and Breece appealed.
Breece’s claim of homestead exemption was based on Ohio’s exemption statute, which allows an exemption for “the person’s interest, not to exceed [$21,625], in one parcel or item of real or personal property that the person or a dependent of the person uses as a residence.” Ohio Rev. Code § 2329.66(A)(1)(b). The Bankruptcy Appellate Panel therefore had to determine whether Breece had a sufficient interest in her home to satisfy the Ohio statute.
Breece contended that her interest in the residence was sufficient because it was derivative of her interest in the LLC. For example, absent the bankruptcy filing she would be entitled to a distribution of the residence on dissolution of the LLC. Breece, 2013 WL 197399, at *3.
Court’s Analysis. The court began by examining Ohio’s LLC Act. The Act provides that an LLC is a separate legal entity and that a member’s interest in an LLC is personal property. Ohio Rev. Code § 1705.01, § 1705.17. Any real estate owned by an LLC is owned solely by the LLC, and a member has no specific interest in property owned by the LLC. Ohio Rev. Code § 1705.34.
The court then reviewed a decision from the Northern District of Ohio Bankruptcy Court that was closely on point, with very similar facts, In re Stewart, No. 09-7257 (Bankr. N.D. Ohio, Oct. 1, 2010). The arguments and the Stewart court’s conclusions were three-fold. First, the debtors (husband and wife) argued that as sole members of the Delaware LLC, they had an interest in the real estate. But the Stewart court found that under both Ohio and Delaware law, the real estate was owned by the LLC and the members had no ownership interest in the LLC’s property. Stewart, slip op. at 6.
Second, the debtors argued that they had an oral lease in the property, which qualified as an exempt interest under the Ohio statute. The court found, however, that the debtors had only a tenancy at will, which did not qualify as an exempt interest under the statute. Id. at 8.
Third, the debtors raised the alter-ego doctrine and claimed the court should disregard the separate nature of the LLC. The court said that under Ohio law the alter-ego doctrine only applies to third parties and as justice requires, and declined to apply an alter-ego construction. Id. at 11.
The Breece court agreed with the Stewart analysis: “Based on Ohio law, this Panel concludes that the bankruptcy court correctly held that [Breece’s] membership interest in [the LLC] does not bestow on her an interest in the Real Property.” Breece, 2013 WL 197399, at *5.
Breece also argued that Ohio’s homestead exemption should be construed liberally, and that the court should focus on the statute’s reference to the debtor’s use of the property: “real or personal property that the person or a dependent of the person uses as a residence.” Ohio Rev. Code § 2329.66(A)(1)(b) (emphasis added). The court was unconvinced, and found the debtor’s use and possession of the property as a residence to be a necessary but not a sufficient condition for the exemption.
Breece contended that her LLC’s ownership of the residence gave her an equitable interest in the residence. She referenced an Ohio case which had held that equitable title to the debtor’s residence was sufficient to qualify for the homestead exemption. The court pointed out that the equitable title in the earlier case was nothing more than a financing mechanism, which gave the beneficial owner the right to acquire legal title on payment of the debt, and rejected Breece’s equitable-interest argument.
Property of the Estate. The Bankruptcy Code provides that the homestead exemption only applies to property of the estate. Breece, 2013 WL 197399,at *8; see 11 U.S.C. § 522(b). “Property of the estate” is broadly defined at 11 U.S.C. § 541(a), but it does not reach further than the rights the debtor had in property at the commencement of the bankruptcy case. Breece, 2013 WL 197399, at *8.
The court again reviewed Ohio’s LLC Act, emphasized that LLC members do not own the property owned by the LLC and that LLCs are separate and distinct entities, and held that neither the residence nor any interest in the residence is property of the estate. Id. at *9. The homestead exemption therefore could not apply.
In summary, the court held that Breece did not hold an interest in her residence that qualified her for Ohio’s homestead exemption, and that Breece could not claim a homestead exemption because neither the residence nor any interest in it was property of the estate. The court rejected Breece’s homestead exemption claim and affirmed the Bankruptcy Court’s disallowance.
Comment. The court’s conclusions are admirably supported by citations to statutes and case law, but the trees appear to have obscured the court’s view of the forest.
The policies behind the Bankruptcy Code include providing debtors with a clean start and using property exemptions to avoid leaving families destitute and homeless after a bankruptcy. The bankruptcy courts recognize that exemption statutes are generally to be liberally construed in a debtor’s favor, and the Ohio Supreme Court has long recognized that exemption statutes should receive as liberal a construction as can fairly be given to them. Stewart, slip op. at 4-5.
Against that backdrop, consider that there is no other human being with any interest in Breece’s home, whether legal, equitable, direct, indirect, beneficial, or otherwise, other than the owners of the mortgage holder. Consider also that “interest” is neither defined nor limited in the Ohio homestead exemption statute. Breece obviously holds an interest of some sort in the property, whether it be characterized as inchoate or indirect. She controls the LLC and could at any time transfer legal title of the property to herself. Instead of recognizing that reality, the Breece court exalted form over substance and held that Breece had no interest in her home.
Barring further review, though, the Breece result stands. Is there a way for a homeowner to hold his or her residence in a single-member LLC and still preserve the homestead exemption? One possibility would be to execute a written lease from the LLC to the homeowner, with a definite term and some level of rent payment. Because there would be no other members in the LLC, the rent would not have to be at market.
Recall that in Stewart the debtors contended they had an interest in the property because they had an oral lease, but the court found that it was nothing more than a tenancy at will. A written lease with a definite term should normally be construed as creating a real estate interest in the property.
Bankruptcy Appellate Panel Says Out-Of-State Member's Interest in Nevada LLC Is Located in Nevada for Venue Purposes
It sounds like the beginning of a bad joke. An individual walks into a bar and says “Where’s my LLC?” But that was the question a Bankruptcy Appellate Panel recently had to answer. The court had to determine whether Nevada was the proper venue in an involuntary bankruptcy case. The debtor’s only connection with Nevada was that his principal assets consisted of interests in a Nevada LLC and a Nevada limited partnership. The creditor claimed that venue in Nevada was proper because the LLC and the partnership were formed under Nevada law and therefore the debtor’s interests in the companies were located in Nevada. The debtor contended that his LLC and partnership interests were located where he resided, in Washington.
The case began in 2011 when the Montana Department of Revenue (MDOR) filed an involuntary chapter 7 bankruptcy petition in Nevada against Timothy Blixseth. In re Blixseth, 484 B.R. 360 (B.A.P. 9th Cir. Dec. 17, 2012). The petition asserted that venue was proper in Nevada because Blixseth had assets in Nevada. (Venue for a bankruptcy case may be based on any of four alternatives: the debtor’s (i) domicile, (ii) residence, (iii) principal place of business in the U.S., or (iv) principal assets’ location in the U.S. 28 U.S.C. § 1408(1).)
Shortly after the petition was filed the bankruptcy court on its own initiative entered an order to show cause why venue was proper in Nevada, and expressed a concern about “the paucity of the connection between Blixseth and … the selected venue.” Blixseth, 484 B.R. at 362. MDOR responded that venue was proper in Nevada because Blixseth’s principal assets were his interests in Desert Ranch LLLP, a Nevada limited liability limited partnership, and in Desert Ranch Management LLC, a Nevada limited liability company.
Blixseth took the court’s hint and filed a motion to dismiss. He argued that venue was not proper in Nevada because he had resided in Washington since 2007, he conducted no business in Nevada, he had no place of business in Nevada, and he had no property in Nevada. He did acknowledge that his primary assets were his interests in Desert Ranch LLLP and Desert Ranch Management LLC. The LLLP owned real estate in the U.S. and abroad, and the LLC owned an interest in the LLLP and was its general partner.
The trial court concluded that intangible ownership interests, such as Blixseth’s interests in the LLLP and the LLC, have no physical location and that therefore venue based on the location of Blixseth’s assets was unavailable. The trial court also held, in the alternative, that if Blixseth’s interests in the two companies had a location it was at his residence, which was in Washington. Venue based on the location of Blixseth’s assets was therefore unavailable, and “because it was undisputed that Blixseth did not reside, was not domiciled, and did not have a principal place of business in Nevada, there was no other basis for venue in Nevada.” Id. at 364. The trial court concluded that venue in Nevada was incorrect and dismissed the petition, and MDOR appealed.
Issue on Appeal. The Bankruptcy Appellate Panel phrased the sole issue as “whether, for venue purposes under 28 U.S.C. § 1408(1), Blixseth’s principal assets, consisting of his intangible equity interests in Desert Ranch and Desert Management, were located in Nevada.” Id. at 365.
The court characterized Blixseth’s interests in the LLC and the LLLP as intangible property having no physical location – “the location or situs of intangible property is a ‘legal fiction.’” Id. at 366 (citation omitted). The court noted that the legal location of intangible property is protean: intangible property may be located in multiple places for different purposes. The court looked to the Ninth Circuit’s rule that for venue purposes the court should use a context-specific analysis and employ a “common sense appraisal of the requirements of justice and convenience in particular conditions.” Id. at 366-67 (quoting Office Depot Inc. v. Zuccarini, 596 F.3d 696, 702 (9th Cir. 2010)).
Applying the Ninth Circuit’s “context-specific” analysis, the court focused on the trustee’s duty to administer the bankruptcy estate and realize on the assets for the benefit of Blixseth’s creditors. The trustee will have the same rights as Blixseth’s creditors to realize on his interests in the LLC and the LLLP. 11 U.S.C. § 544(a)(1).
Because the LLC and the LLLP were formed under Nevada law they are governed by Nevada law, including its rules on the rights of creditors. Under Nevada law the only remedy of a judgment creditor of an LLC member or LLLP partner is to apply to a Nevada court for a charging order. Nev. Rev. Stat. § 86.401 (LLCs); Nev. Rev. Stat. § 88.535 (LLLPs).
The court found that “because Blixseth’s interests in the LLC and LLLP were created and exist under, and his creditor’s remedies are limited by, Nevada state law, that is sufficient reason to deem Blixseth’s interests to be located in Nevada.” Blixseth, 484 B.R. at 369. The court found additional support for its conclusion in the Nevada courts’ exclusive jurisdiction over judicial dissolution of the LLC and the LLLP, given that the trustee might seek the dissolution of the companies in order to reach the assets owned by each. Id. at 369-70.
The court also looked to notions of justice and convenience. The court found it disingenuous for Blixseth to argue that Nevada is not a proper venue for his creditors to pursue his interests in the two companies, given his choice to form them under Nevada law. Also, it would be more convenient for a Nevada trustee than for a trustee appointed in Washington (the venue argued for by Blixseth) to apply to the Nevada courts to obtain a charging order or request dissolution of the LLC or the LLLP. Id. at 370-71.
Accordingly, the court held that Blixseth’s interests in Desert Ranch and Desert Management were deemed to be located in Nevada, and that venue in Nevada was proper. Id. at 371.
Comment. Business people and investors who decide to form an LLC must decide which state law to form it under. Nevada is sometimes held out as a haven for the formation of asset-protection LLCs. Corporate service companies or law firms will sometimes encourage even out-of-state business startups to organize as a Nevada LLC.
The Blixseth case shows the potential for unintended consequences when picking Nevada or any other state as an LLC’s state of formation, if the LLC’s principal owner has no other connection to the state chosen. The owner can find itself litigating in the state where the LLC was formed, even though the owner does not live there, has no business activities there, and owns no other assets there. That’s usually less convenient than litigating in one’s home state.
In fact, the differences between Nevada’s LLC statute and the LLC statutes of other states are not huge. All states’ statutes protect an LLC’s members and managers from liability for the LLC’s contracts and actions, and no state’s law will protect a member from legal liability for the harm caused directly by the member. All state LLC acts are written to provide a high degree of flexibility for the members in structuring their LLC.
There are sometimes good reasons to pick a state of formation other than one’s own state, but the factors should be considered carefully, including the potential for litigation far from home.
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.
The U.S. Bankruptcy Court for the Eastern District of Tennessee ruled in August that an LLC’s creditor could not pierce the LLC’s veil to assert its claim against the LLC’s sole member. In a twist, the LLC’s member, not the LLC, was the debtor in bankruptcy. In re Steffner, No. 11-51315, 2012 WL 3563978 (Bankr. E.D. Tenn., Aug. 17, 2012).
Veil-piercing cases arise frequently, but Steffner presents an unusual posture. Veil-piercing claims are often asserted when an LLC’s creditor wants to add a claim against someone with more assets than the LLC, such as a member of the LLC. But when the object of the veil-piercing claim (the LLC member) is in bankruptcy, even a successful attempt to pierce the LLC’s veil will result in the plaintiff being an unsecured creditor in the bankruptcy, likely receiving only cents on the dollar.
Hulsing Hotels Tennessee, Inc. obtained a state court judgment against Sleep Quest Diagnostics, LLC in 2009. Edward Steffner, Sleep Quest’s sole member, filed for bankruptcy in 2011. Hulsing then commenced an adversary proceeding in Steffner’s bankruptcy, to pierce the veil of Sleep Quest and assert Hulsing’s Sleep Quest judgment against Steffner. Hulsing also requested denial of Steffner’s bankruptcy discharge, which would have allowed Hulsing to continue to assert its claim post-bankruptcy.
Hulsing based its veil-piercing claim on the following: (1) Sleep Quest and Specialty Respiratory Services, LLC (SRS), another entity owned by Steffner, shared the same office building, bank, and accountant; (2) on the day that Hulsing served a garnishment on Sleep Quest’s bank account, Sleep Quest transferred $4,886 from the account to SRS, leaving a balance of only 17 cents; (3) when Steffner learned that Hulsing had garnished funds owed to Sleep Quest by two insurance companies, Steffner informed Sleep Quest’s bank, which held a perfected security interest on Sleep Quest’s accounts receivable, and the bank filed a motion in state court to quash Hulsing’s garnishment; (4) there had been numerous transfers of funds between Sleep Quest and SRS; (5) Sleep Quest had filed a number of reimbursement claims with the two insurance companies under a third-party physician’s provider number; and (6) Steffner’s initial filing of the list of his creditors in the Bankruptcy Court included the business debts of Sleep Quest and SRS.
The Bankruptcy Court applied Tennessee law, which will disregard the veil of an LLC’s liability shield and hold its members liable for the LLC’s debts when it “is a sham or a dummy or where necessary to accomplish justice,” when there is misconduct on the part of officers or directors, when the entity is created or used for an improper purpose, or when the entity’s form has been abused. Id. at *4 (quoting Schlater v. Haynie, 833 S.W.2d 919, 925 (Tenn. Ct. App. 1991)). The standards are the same for an LLC as for a corporation, and are to be applied cautiously and with a presumption of corporate regularity. Id.
A number of factors should be considered in determining whether to pierce the veil of a corporation or an LLC: undercapitalization, diversion of corporate assets, and the failure to maintain arm’s-length relations among related parties, among others. No one factor is conclusive, and it is not required that all of the factors weigh in favor of piercing the veil. Id. at *5.
The Steffner court systematically analyzed Hulsing’s contentions. Although Sleep Quest and SRS operated out of the same building (in different suites) and used the same bank, attorneys, and accountants, the two companies were formed at different times and for different purposes. The court pointed out that closely held businesses often use the same professionals for convenience, and the professionals and businesses who dealt with Steffner and the two companies treated them as separate entities. Id.
The transfers between Sleep Quest and SRS were documented as loans in the companies’ internal accounting records. The transfer of $4,886 on the day of Hulsing’s garnishment of the bank account was documented as a loan, with the result shown as a receivable on Sleep Quest’s books. The court saw that the timing of that transfer may have been “more than coincidental” but found that was not enough to pierce the veil. Id.
The court found Steffner’s disclosure to Sleep Quest’s bank that Hulsing had garnished Sleep Quest’s receivables that were the subject of the bank’s perfected security interest to be nonobjectionable. “Merely preferring one creditor over another is not a basis for piercing the corporate veil.” Id. at *6. And Sleep Quest’s use of an identifier number other than its own was not illegal or fraudulent, and did not divert or conceal any funds due to Sleep Quest.
The Steffners had initially listed the debts of Sleep Quest and SRS in their bankruptcy schedules, but the court saw that as a common practice, intended to give notice to all creditors who might have a claim against the debtor. Those debts would normally be listed as disputed, but Steffner made that clear at the meeting of creditors and in subsequent amendments to the schedules.
The court concluded that Sleep Quest was not a sham or a fraud and that the corporate formalities had been observed. Steffner had not used the LLC form of Sleep Quest for an improper purpose, and there was no misconduct by Steffner. Id. at *8. The court therefore dismissed Hulsing’s veil-piercing claim against Steffner.
Comment. Veil-piercing cases are noted for their lack of predictability, and sometimes courts strain to pierce the veil when the LLC has only a single member. For example, earlier this year I posted here about Colorado’s Martin v. Freeman case, where the veil of a single-member LLC was pierced without any showing of wrongdoing.
The Bankruptcy Court in Steffner took a more even-handed approach. The court put no undue emphasis on Steffner’s sole ownership of the LLC and rejected the veil-piercing claim, implicitly recognizing the legitimacy of an LLC’s liability shield even for single-member LLCs.
The court’s analysis also underscores the importance of properly documenting transactions between affiliated companies. There were numerous transfers of cash between the two companies in Steffner, but they were all reflected as loans in their accounting records. If those cash flows had not been properly booked, the case likely would have come out the other way.
Charles McSwain, a 53% member of Hawks Prairie Casino, LLC, a Washington LLC, filed a voluntary Chapter 11 bankruptcy petition in 2007. Hawks Prairie operates a gambling casino in Thurston County, Washington.
Background. The President of Hawks Prairie, Tryna Norberg, knew of McSwain’s bankruptcy filing and continued to treat him as a voting member of the LLC until early 2009, when McSwain called on her to resign and threatened to call a meeting to appoint a new President. Shortly thereafter Hawks Prairie informed McSwain that he was dissociated from the LLC, and after that he received no further member communications from the LLC.
Several months later McSwain filed his plan of reorganization. The plan provided that upon its confirmation by the court, all of McSwain’s rights and interests in the LLC, as they existed immediately prior to the bankruptcy filing, would be automatically reinstated. That would restore his member voting rights and give him majority control of the LLC.
Norberg objected to confirmation on the grounds that full reinstatement of McSwain’s member interest was inconsistent with the LLC’s Operating Agreement and Washington law, and that under Bankruptcy Code Section 365(c)(1) McSwain was precluded from assuming the voting and other management rights of a member. Norberg sought a declaration that McSwain no longer possessed any management rights in the LLC, and that his interests in the LLC were solely those of an assignee, i.e., he had only the right to share in profits, losses, and distributions. Norberg v. Hawks Prairie Casino, LLC (In re McSwain), No. 07-43338, 2011 Bankr. LEXIS 3921, at *2 (Bankr. W.D. Wash. Oct. 6, 2011).
Washington’s LLC Act provides that an LLC member is dissociated, ceases to be a member, and takes on the status of an assignee upon the member’s insolvency or bankruptcy, unless the LLC agreement provides otherwise or the members all consent in writing. RCW 25.15.130(1)(d). (Many other states have similar provisions. E.g., Del. Code Ann. tit. 6, § 18-304.)
The Hawks Prairie Operating Agreement was clear: A member that files a voluntary bankruptcy is dissociated and treated as an assignee rather than as a member, unless all other members consent or 70% of the initial members consent. McSwain, 2011 Bankr. LEXIS 3921, at *7-8. Washington’s LLC Act therefore barred McSwain from being readmitted as a member without the requisite member vote, which was not forthcoming.
Bankruptcy Code. The Bankruptcy Code gives a bankruptcy trustee, or the debtor in possession in a Chapter 11 case (as in McSwain),the authority to assume, assign, or reject the executory contracts of the debtor, subject to several limitations. 11 U.S.C. § 365. The issue before the court was whether Bankruptcy Code Section 365(c)(1) prevented McSwain from assuming all his rights as a member. That section is concise:
(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if–
(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(B) such party does not consent to such assumption or assignment[.]
11 U.S.C. § 365(c)(1).
The Ninth Circuit has ruled that this section “by its terms bars a debtor in possession from assuming an executory contract without the nondebtor’s consent where applicable law precludes assignment of the contract to a third party.” Perlman v. Catapult Entm’t, Inc. (In re Catapult Entm’t, Inc.), 165 F.3d 747, 750 (9th Cir. 1999). (In Catapult, the Ninth Circuit joined the Third and Eleventh Circuits in a circuit split on whether Section 365(c)(1) applies to an assumption by the debtor even if a third-party assignment is not contemplated – Catapult concluding that it does.)
Court’s Analysis. The McSwain court concluded that the LLC’s Operating Agreement was an executory contract, and that applicable nonbankruptcy law, i.e., Washington’s LLC Act, forbids its assignment. The court interpreted Catapult as imposing a third requirement: “assignment must be forbidden [by applicable nonbankruptcy law] because the identity of the nondebtor party is material.” McSwain, 2011 Bankr. LEXIS 3921, at *21. The court went on to say: “It is certainly possible that the identity of Hawks Prairie’s other members is material, such that McSwain could not assume the contract.” Id. at *22.
In the event, though, the court concluded it need not determine whether the identity of the members other than McSwain was material. Instead it decided the case on the grounds of an implied waiver by Norberg. From the beginning Norberg was fully aware of McSwain’s bankruptcy and knew that McSwain could be treated as an assignee under the Operating Agreement. She nonetheless permitted McSwain to exercise all the rights of a full member, including attending management meetings and voting on major transactions. Norberg had sent the members multiple emails, letters, and minutes of meetings that referred to McSwain as a member. The court concluded that by her actions Norberg impliedly waived her right to enforce the Operating Agreement’s dissociation provisions against McSwain. Id. at *24. Under the confirmed plan of reorganization, McSwain was therefore entitled to exercise his full membership rights in the LLC, including voting and management rights. Id. at *30.
Comments. The court’s waiver analysis is unexceptional and clearly seems to be the right result. The court’s discussion in dicta of the applicability of the Catapult rule, however, focuses on the identity of the other members in the LLC, and conjectures that if the LLC had a large number of passive members, their identity would not be material and McSwain would then be able to assume his rights as a member. Id. at *22-23.
Catapult, on the other hand, relied on the policy of the nonbankruptcy law that restricts assignment, not on the degree to which the policy applied to the facts of the specific case. Catapult describes Section 365(c)(1) as stating “a carefully crafted exception to the broad rule – where applicable law does not merely recite a general ban on assignment, but instead more specifically ‘excuses a party … from accepting performance from or rendering performance to an entity’ different from the one with which the party originally contracted, the applicable law prevails…. Only if the law prohibits assignment on the rationale that the identity of the contracting party is material to the agreement will subsection (c)(1) rescue it.” Catapult, 165 F.3d at 752.
The dissociation provisions of the LLC Act fit that description well. They preserve the economic rights of the dissociated member, but prevent the dissociated member from interfering in the management of the LLC. This is consistent with the “know your partner” principle, which is reflected in multiple provisions of most state LLC Acts, such as limitations on assignment and the rules on charging orders.
McSwain reached the right result because of Norberg’s implied waiver. But McSwain’s focus on the specific facts of the LLC and its members, rather than the rationale of the nonbankruptcy law that prohibits assignment, is inconsistent with Catapult and should not be relied on.
Given the increasing use of LLCs in business organizations, it seems likely that disputes over the interaction between Bankruptcy Code Section 365(c)(1) and the dissociation provisions of state LLC Acts will continue to arise as LLC members have occasion to file Chapter 11 bankruptcies. There will be further developments.
A Bankruptcy Appellate Panel (BAP) of the Tenth Circuit recently upheld a bankruptcy court’s dismissal of an LLC’s Chapter 11 bankruptcy petition on the ground that the LLC’s operating agreement barred the LLC from filing for bankruptcy. DB Capital Holdings, LLC v. Aspen HH Ventures, LLC (In re DB Capital Holdings, LLC), No. CO-10-046, 2010 Bankr. LEXIS 4176 (B.A.P. 10th Cir., Dec. 6, 2010). Bankruptcy law has long refused to enforce contractual prohibitions on voluntary bankruptcy filings, so this case appears to be a chink in that rule.
DB Capital Holdings, LLC was a Colorado condominium developer whose project was 14 months late and $4 million over its $82 million budget. It had no funds to continue the project and was both insolvent and in breach of its loan agreements with its principal lender. At the lender’s request, a receiver was appointed by a Colorado state court to take charge of and protect the LLC’s project.
The LLC’s two members were in disagreement over the receivership, and the LLC’s sole manager then filed a Chapter 11 bankruptcy petition on behalf of the LLC. At that point one of the members filed a motion to dismiss the Chapter 11 case, claiming that the manager lacked authority because the LLC’s operating agreement barred its bankruptcy filing. The operating agreement stated:
The Company (v) to extent permitted under applicable Law, will not institute proceedings to be adjudicated bankrupt or insolvent; or consent to the institution of bankruptcy or insolvency proceedings against it; or file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy ….
Id. at *9 (ellipsis in original). The bankruptcy court held that the LLC’s operating agreement precluded the manager from filing for bankruptcy on the LLC’s behalf and dismissed the Chapter 11 proceeding.
The BAP began its analysis by noting that “[a] bankruptcy case filed on behalf of an entity without authority under state law to act for that entity is improper and must be dismissed,” and that bankruptcy courts must look to state law to resolve authority issues. Id. at *7. Under the Colorado LLC Act, an LLC’s operating agreement governs the rights and duties of an LLC’s members and managers. Id. The operating agreement language was clear; it expressly barred the LLC from filing a bankruptcy petition.
The manager contended that the operating agreement’s ban on filing a petition was invalid because it had been executed at the creditor’s request and only benefited the creditor. The manager cited numerous cases holding that contractual prohibitions on filing for bankruptcy are unenforceable.
The court distinguished those cases as involving debtor agreements with third parties. “Debtor has not cited any cases standing for the proposition that members of an LLC cannot agree among themselves not to file bankruptcy, and that if they do, such agreement is void as against public policy, nor has the court located any.” Id. at *10. The court found the express restriction on the filing of a bankruptcy petition to be enforceable.
The court also reviewed provisions of the LLC’s operating agreement that required the manager to carry out the LLC’s business “as presently conducted,” and that barred the manger from doing any act that would make it impossible to carry on the ordinary business of the LLC. The court concluded that even without the operating agreement’s express prohibition on filing a petition, the provisions relating to the ordinary business of the LLC, as presently conducted, prohibited the manager from filing a bankruptcy petition.
Although the court upheld the operating agreement’s express bar on any bankruptcy filing by the LLC, it qualified its opinion in a way that introduced some uncertainty about the scope of its opinion:
In addition, Debtor does not point to any record evidence that the May amendment was coerced by a creditor. For that reason, the Court declines to opine whether, under the right set of facts, an LLC’s operating agreement containing terms coerced by a creditor would be unenforceable.
Id. at *10. It’s the word “coerced” that makes one blink. Normally the only reason an LLC agreement would include a prohibition on bankruptcy filings would be that a creditor or some other third party requested it. If “coerced” means that the limitation was put in the LLC agreement at the request of a creditor, this case won’t have much impact.
“Coerced” usually means some undue pressure or threat. Often some element of physical force is involved, which presumably was not the court’s meaning. Is the LLC coerced if a lender offers a loan on terms that require the LLC to include the restriction in its operating agreement? Most lawyers would probably say no, that’s not coercion. Perhaps the court had in mind the type of situation where a company is desperate for a loan and lacks bargaining power.
Assume the bankruptcy courts will generally enforce these restrictions, as the BAP did this case. Can a lender rely on such a restriction in an LLC’s operating agreement? Not standing alone – the operating agreement is an agreement between members, so the members can change their agreement and eliminate the restriction. For the lender to rely on the restriction the lender would need a way to limit the members’ ability to amend the agreement. For example, the lender could be a member or have a representative that would serve as a member, and vote against elimination of the restriction.
A better way, at least if the debtor is a Delaware LLC, may be to rely on Section 18-101(7) of the Delaware LLC Act. That section states: “A limited liability company agreement may provide rights to any person, including a person who is not a party to the limited liability company agreement, to the extent set forth therein.” A Delaware LLC agreement could provide that it could not be amended without the consent of a named third party, such as the lender.