Wednesday, October 15, 2008

Planning for bankruptcy of an LLC member

These are tough economic times. Entering into a business relationship with another individual is much like a marriage, for better or for worse. However, in the business relationship, one is allowed to take precautions against "the worse". What happens when one member of a multi-member LLC goes bankrupt? Absent some provision in the operating agreement to the contrary, the member's LLC ownership interest becomes the property of the debtor's bankruptcy estate. Does the debtor still have the authority to act on behalf of the LLC as a member? Unless the operating agreement addresses this issue, the answer depends on which state your LLC is organized in. Some states such as Florida have a specific statute in their LLC code stating that a person ceases to be a member upon filing for bankruptcy. See Florida Stat. § 608.4237 and Uniform Limited Liability Company Act § 601(7).

How does this effect drafting of LLC operating agreements? As not all state LLC acts, to my knowledge, automatically terminate a member's right to vote and participate in the management of an LLC when filing a petition in bankruptcy, it is prudent to write such a provision into the operating agreement. But see below caveat. If the member becomes disassociate, the next issue is what does that member receive in return for his or her membership interest upon disassociation? One turns first to the operating agreement to see if this is spelled out and, if not, then the default provision of the state LLC act control. Using Florida as an example again, I believe Florida Stat. § 608.427 speaks to this situation even though it uses the words "withdraw" of a member rather than ceasing to be a member by operation of law. Section 608.427 states that the withdrawing member receives "the fair value of the withdrawing member's interest". Trust me, that's nearly impossible to calculate in closely held, small business LLCs. There is no market for small business LLC interests so basically one is left with hiring accountants to pull numbers out of their ass, which often leads to litigation. Thus, the smart move is to set forth in the operating agreement exactly what the disassociated member receive upon filing for bankruptcy. Examples include the member's capital account, some multiple of past earnings of the LLC then multiplied by the member's ownership percentage, book value of the LLC multiplied by the member's ownership interest, or naming a specific outside expert to value the departing member's interest if agreement cannot be reached. These examples require the LLC to come up with capital to pay off the departing member in a reasonably short time frame. That may place a burden on the LLC. Another option is for the disassociate member to be stripped of management and voting power within the LLC but to retain all rights to distributions otherwise payable to his or her ownership interest.

As with everything in the law, exception apply. What about a professional service LLC or one whether a significant chunk of the LLC is tied to specific members? It may not be in the best interest of the LLC as a whole to automatically expel a member generating significant revenue for the LLC upon the filing a petition for bankruptcy. In such case, perhaps the prudent course is to suspend the member's voting rights during bankruptcy and, further, limit the bankrupt member's ownership rights to those of an assign (i.e., retains right receive distributions otherwise payable to the LLC ownership interest).

9 comments:

window said...

my Husband and I have a business, which is a LLC. If our business files bankruptcy, will they take our personnal stuff at home or does the LLC protect us

Joe said...

Generally an LLC does provide personal protection against business debts but, to my knowledge, there are two substantial exceptions. First, business debts that have been personally guaranteed (or co-signed) by the LLC member. Second, when distributions have been made from the LLC to the members at a time when the LLC is insolvent. It's a situation for which a bankruptcy attorney would need to review the business records and financials to give you a solid opinion.

tamara said...

If I am reading your post correctly, if a member of an LLC in Florida files bankruptcy and there is no provision in an operating agreement to say otherwise, then the ownership of that member is terminated upon filing. Is that corrrect? If so, when and if can the terminated owner reinstate his or her membership/ownership?

jjray said...

Tamara, the ownership of the member is not terminated, only the person's status as a member. Essentially this means that upon bankruptcy former member still holds an economic interest in the LLC but is not longer able to vote as a member nor otherwise take part in the management of the LLC.

Tom said...

I'm hoping you can give me insight on a somewhat complex situation in Colorado, pretty much the opposite of window's question.
My wife and I have 2 businesses, one is an S-corp, the other is an LLC. The S-corp is now defunct, leaving a large debt, a portion of which is personally guaranteed. The LLC is solvent and producing just enough income to meet the mortgage & bills.
I am looking into bankruptcy on the S-corp and personal debts. Can we do this and still keep the LLC and it's equity protected from the bankruptcy?

jjray said...

Sorry Tom, you need to take that question to bankruptcy attorney. If both you and your wife personally guaranteed the debt from the S corp and the two of you are the sole members of the LLC, I don't think it looks good but check with a bankruptcy attorney. I have not looked at this issue in a several years.

Diana said...

my husband and I are majority members of the LLC. The LLC is insolvent and in deep debt, but our third partner wishes to try to salvage the business. We are filing for Ch 7 personally and want to include all debts that we owe through LLC and personally in filing. What's the best way for us to leave fast and to leave all the shares of the LLC to him?

Bennis said...

My wife and friend are involved in a gift shop which is an LLC in MS. Her partner we believe is filing Bankruptcy on her personal debt and were not sure where this is going to leave the business? All the money for the business has been supplied by us and this is a first year business so still has no profit? it is a 50 share each business.

jjray said...

A person "ceases to be a member of a limited liability company" upon filing a petition in bankruptcy under MS law.
http://www.mscode.com/free/statutes/79/029/0307.htm

What's that mean? You need to take the matter to a local attorney for further guidance but the most likely outcome is that the member who files for bankruptcy becomes a holder of an economic interest of the LLC and no longer a member. That means the disassociated member can no longer vote but is entitled to the share of the profits of the LLC that he / she had been as a member.