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).