Wednesday, September 7, 2011

Bankruptcy of Member--California LLC

Question: We have an LLC in California with 4 equal members. Two members are going through Ch.13 bankruptcy. Our operating agreement states that the LLC shall be dissolved by bankruptcy of a member. It also states that if at least two members remain they can vote to continue the company within 90 days. If the two remaining members vote to continue the company does that mean the two members in bankruptcy only have an economic interest in the company? Does just filing for bankruptcy dissolve the LLC or does the court need to take their ownership in order for the LLC to be dissolved?
Answer: The bankruptcy of a member is not an event of dissolution under the California LLC Act, see Cali. Corp. Code § 17350, et alia. Thus, unless your LLC operating agreement clearly states that the company is to be dissolved due to the events described above, there is no dissolution. It comes down to interpretation of the LLC operating agreement. More importantly, I believe the burden will be on those members wishing the LLC to be dissolved to show that events have occurred that require dissolution of the LLC under the operating agreement. Those members wishing dissolution will have to file a petition with the court claiming an event of dissolution has occurred under the operating agreement per Section 17350.(a).

Your ultimate questions seems to be what happens to the interests of the members who declared bankruptcy if the company is able to continue. The LLC Acts of most states explicitly provides that status as an LLC member ends upon the filing of bankruptcy petition and, thereafter, the member (or his bankruptcy estate) is merely a holder of an economic interest. For example, see Del. LLC Code § 18-304. Events of bankruptcy. I could not find a section in the California LLC Act specifically addressing bankruptcy of a member such as the linked section from the Delaware Act; however, there are several provisions in the California Act regarding assigned of LLC members interests that I think essentially get one to the same place.
Cal. Corp. Code. § 17300. A membership interest and an economic interest in a limited liability company constitute personal property of the member or assignee. A member or assignee has no interest in specific limited liability company property.

Cal. Corp. Code. § 17302. (a) On application by a judgment creditor of a member or of a member's assignee, a court having jurisdiction may charge the assignable membership interest of the judgment debtor to satisfy the judgment. The court may appoint a receiver of the share of the distributions due or to become due to the judgment debtor in respect to the limited liability company and may make all other orders, directions, accounts, and inquiries that the judgment debtor might have made or that the circumstances of the case may require.

Cal. Corp. Code. § 17303. (a) Except as otherwise provided in the articles of organization or the operating agreement, an assignee of an interest in a limited liability company may become a member only if a majority in interest of the other members vote in favor of the assignee's admission to the limited liability company as a member.
These are default provisions of the California LLC Act for the situation where a creditor takes possession through assignment of a member's interest in the company. They apply when the operating agreement is silent on the issue. If your operating agreement states that a member becomes an economic interest holder upon filing bankruptcy, then it controls over the Cali. LLC Act. Under the California LLC Act, it looks like the bankruptcy estate of the members who declared bankruptcy are essentially assignees of the member-debtor and, thus, only entitled to a charging order and, further, are not entitled to become members of the LLC.

Please take the issue to a local bankruptcy attorney for a legal opinion on this issue.


Anonymous said...

Thank you for your answer. The operating agreement does specifically list bankruptcy as an event for dissolution and gives the remaining members an option to continue the business. It doesn't state Ch13 or Ch7 bankruptcy so I am assuming either one would be the same.

I'm just confused because they are doing Ch13 payment plan and may keep their interest in the LLC if they complete the Ch13 plan. I just wanted to know if they would lose their membership in the LLC regardless because they filed for bankruptcy.

jjray said...

As the article states, I did not find a clear cut provision in Cali. LLC Act (such as one finds in Del.) that specifically states that a member becomes merely an economic interest holder at the moment he files for bankruptcy. The Cali. statutes site seem to indicate that this would be the case but I can't say for sure through a quick check. You must take the matter to a local attorney knowledgeable in Cali. corporate law for an opinion on the issue.