What Happens When an LLC Member Files Bankruptcy

What happens to a member’s LLC interest when the member files bankruptcy?

The member’s interest in the LLC becomes property of the bankruptcy estate when the case begins. In a chapter 7 case, a trustee takes charge of it with a duty to collect and reduce estate property to money. In chapter 11, the member as debtor in possession holds a trustee’s powers; in chapter 13, the member keeps possession.

With exceptions the statute lists, the estate includes “all legal or equitable interests of the debtor in property as of the commencement of the case” (11 U.S.C. § 541(a)(1)). The debtor is the member, not the company, so the case reaches what the member owns: the interest in the LLC. Minnesota law treats the money side of that interest as property. “A transferable interest is personal property” (Minn. Stat. § 322C.0501). A transferable interest is “the right, as originally associated with a person’s capacity as a member, to receive distributions from a limited liability company in accordance with the operating agreement” (Minn. Stat. § 322C.0102 subd. 28).

Who controls the interest depends on the chapter. A chapter 7 trustee must “collect and reduce to money the property of the estate for which such trustee serves” (11 U.S.C. § 704(a)(1)). For the other owners, a chapter 7 filing puts the member’s stake under that duty. A sale is still not certain: “an individual debtor may exempt from property of the estate the property listed” in the Code (11 U.S.C. § 522(b)(1)), and “the trustee may abandon any property of the estate that is burdensome to the estate or that is of inconsequential value and benefit to the estate” (11 U.S.C. § 554(a)). In chapter 11, “a debtor in possession shall have all the rights, other than the right to compensation under section 330 of this title, and powers, and shall perform all the functions and duties, except the duties specified in sections 1106(a)(2), (3), and (4) of this title, of a trustee serving in a case under this chapter” (11 U.S.C. § 1107(a)). In chapter 13, “Except as provided in a confirmed plan or order confirming a plan, the debtor shall remain in possession of all property of the estate” (11 U.S.C. § 1306(b)), and the debtor holds a trustee’s sale powers under § 363(b) “exclusive of the trustee” (11 U.S.C. § 1303).

When does bankruptcy end a member’s management rights under Minnesota law?

Under Minnesota’s default rules, a member of a member-managed LLC is dissociated, meaning the person stops being a member, upon becoming a debtor in bankruptcy. That statutory rule does not reach a manager-managed LLC. An operating agreement can make bankruptcy a dissociation event in either kind of company.

Minn. Stat. § 322C.0602 lists the dissociation events. Clause (7) applies “in a member-managed limited liability company” when the person “becomes a debtor in bankruptcy.” Clause (2) adds any “event stated in the operating agreement as causing the person’s dissociation.” Your company is member-managed unless its agreement says otherwise: “a limited liability company is a member-managed limited liability company unless the operating agreement” expressly provides for managers or a board or “includes words of similar import” (Minn. Stat. § 322C.0407 subd. 1). For an older company, “the language in the articles of organization, and any bylaws, operating agreement, or member control agreement of a limited liability company formed before August 1, 2015, that becomes subject to this chapter will operate as if that language were in the operating agreement” (Minn. Stat. § 322C.1204 subd. 3).

When dissociation happens, Minn. Stat. § 322C.0603 subd. 1 sets three results:

1. Management. “the person’s right to participate as a member in the management and conduct of the company’s activities terminates.”
2. Fiduciary duties. In a member-managed company, the person’s duties as a member end for “matters arising and events occurring after the person’s dissociation.”
3. Ownership. The person’s transferable interest “is owned by the person solely as a transferee.”

A bankruptcy dissociation before the company ends is also wrongful under Minn. Stat. § 322C.0601 subd. 2, which covers a person “dissociated under section 322C.0602, clause (7), item (i), by becoming a debtor in bankruptcy.” Where the agreement makes bankruptcy a dissociation event and the member also serves as a manager, “the dissociation of a member that is also a manager removes the person as a manager” (§ 322C.0407 subd. 3). Section 322C.0602 also lists the other ways out, including expelling a member from a Minnesota LLC and a member who resigns. Whether the bankruptcy rule actually takes effect once a case is open is a federal question.

How does federal bankruptcy law limit Minnesota’s dissociation rule?

Federal law brings a debtor’s interest into the bankruptcy estate even when a state law or an agreement would end or forfeit that interest because of the filing. That text describes a rule like Minnesota’s, so the member’s management rights may survive into the bankruptcy case. The bankruptcy judge decides.

Under 11 U.S.C. § 541(c)(1), an interest enters the estate “notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law” of two kinds. One kind “restricts or conditions transfer of such interest by the debtor.” The other “is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title,” among other triggers, “and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.” Minnesota’s clause (7) is triggered by a bankruptcy filing and ends the member’s management rights. Whether those rights count as an interest in property is part of what the bankruptcy judge decides.

A second federal rule applies if the operating agreement is an executory contract, meaning a contract with performance still due on both sides. The trustee, “subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor” (11 U.S.C. § 365(a)). Rights under such a contract “may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on” the bankruptcy (§ 365(e)(1)). That protection has an exception. It does not apply where “applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to the trustee or to an assignee of such contract or lease,” and “such party does not consent to such assumption or assignment” (§ 365(e)(2)).

For co-owners, a member’s bankruptcy opens a question in federal court. A plan that treats the member as automatically removed on the filing date rests on a state rule the bankruptcy judge may decline to enforce as written.

Why can’t the other members enforce a bankruptcy buyout clause on their own?

Once the petition is filed, an automatic stay bars “any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate,” and the member’s LLC interest is estate property. Exercising a buyout option without the bankruptcy court is an act to obtain possession of that property.

The stay in 11 U.S.C. § 362(a) “operates as a stay, applicable to all entities,” which includes the company and every other member, not only creditors. Clause (3) of that subsection is the one quoted above. An operating agreement may give the company or the other members a right to buy a member’s interest when the member files bankruptcy. Section 541(c)(1) addresses a bankruptcy-conditioned provision that “gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.” Under 11 U.S.C. § 363(l), “Subject to the provisions of section 365, the trustee may use, sell, or lease property under subsection (b) or (c) of this section” even when such a provision exists.

I suggest treating every bankruptcy trigger in your agreement as a starting point for negotiation in the bankruptcy case, because acting on it unilaterally runs into the stay. The buyout price formula in your agreement still gives you a figure to bring to that negotiation.

How can the remaining members buy out the bankrupt member’s interest?

The remaining members can offer to buy the interest from whoever holds the sale power: the chapter 7 trustee, the chapter 11 debtor in possession, or the chapter 13 debtor. A sale outside the ordinary course of business requires “notice and a hearing” in the bankruptcy court, so the purchase agreement should be written as a sale the court can approve.

Under 11 U.S.C. § 363(b)(1), “The trustee, after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, property of the estate.” A chapter 7 trustee’s duty to “collect and reduce to money” estate property (11 U.S.C. § 704(a)(1)) gives the trustee a reason to sell unless the interest is exempted or abandoned.

An outside buyer gets less than you may think. Under Minnesota law, a transfer of a transferable interest does not entitle the buyer to “participate in the management or conduct of the company’s activities” (Minn. Stat. § 322C.0502 subd. 1). The buyer gets “distributions to which the transferor would otherwise be entitled” (subd. 2) and no vote. That can make the co-owners the buyer who values the stake most, because it pays only when the company chooses to distribute. Your agreement’s transfer limits matter too: “A transfer of a transferable interest in violation of a restriction on transfer contained in the operating agreement is ineffective as to a person having notice of the restriction at the time of transfer” (subd. 6). Section 541(c)(1) still brings the interest into the estate despite a provision that “restricts or conditions transfer of such interest by the debtor.”

A written purchase agreement for a sale out of the estate should cover four points:

1. What is sold. The agreement should say whether the sale covers the transferable interest alone or every right the member held, because the two carry different rights.
2. Price. The agreement should state the price and how it was set, because the court will see the sale at the hearing. The pricing methods are covered in how a co-owner buyout is priced.
3. Court approval. The agreement should make court approval a condition of closing, because § 363(b)(1) requires notice and a hearing.
4. Claims. The agreement should say what happens to claims between the company and the member, because the sale and those claims may otherwise be decided separately.

How should the company handle distributions and records during the case?

The company keeps its discretion over whether to make distributions, but a distribution on the bankrupt member’s interest belongs to the estate and, in a chapter 7 case, should go where the trustee directs. The trustee can obtain company records through the bankruptcy court even where Minnesota’s records statute would not reach them.

A person “has a right to a distribution before the dissolution and winding up of a limited liability company only if the company decides to make an interim distribution” (Minn. Stat. § 322C.0404 subd. 2). When the company does distribute, the statute’s default rule is that distributions “must be in equal shares among members and dissociated members, except to the extent necessary to comply with any transfer effective under section 322C.0502 and any charging order in effect under section 322C.0503” (subd. 1). That default applies only “To the extent the operating agreement does not otherwise provide” (Minn. Stat. § 322C.0110 subd. 2), and for a company “formed before August 1, 2015,” subject to its operating agreement, “section 322C.0404, subdivision 1, does not apply to the limited liability company” (Minn. Stat. § 322C.1204 subd. 3). The estate includes “Proceeds, product, offspring, rents, or profits of or from property of the estate, except such as are earnings from services performed by an individual debtor after the commencement of the case” (11 U.S.C. § 541(a)(6)). In a chapter 7 case, I suggest getting the trustee’s payment instructions in writing before the next distribution, because the trustee’s duty is to collect estate property. In an individual’s chapter 11 case, “the debtor shall remain in possession of all property of the estate” except as section 1104, a confirmed plan, or an order provides (11 U.S.C. § 1115(b)), and § 1306(b) says the same for chapter 13.

Records follow a different path. A dissociated member “may have access to information to which the person was entitled while a member if the information pertains to the period during which the person was a member” (Minn. Stat. § 322C.0410 subd. 3), if “the person seeks the information in good faith, and the person satisfies the requirements imposed on a member by subdivision 2, clause (2).” Those requirements are a purpose “material to the member’s interest as a member,” a demand in a record “describing with reasonable particularity the information sought and the purpose for seeking the information,” and information “directly connected to the member’s purpose” (subd. 2). “The rights under this section do not extend to a person as transferee” (subd. 6). The bankruptcy rules supply their own route. “On a party in interest’s motion, the court may order the examination of any entity,” on topics including “the debtor’s acts, conduct, or property,” and “an entity may be compelled under Rule 9016 to attend and produce documents or electronically stored information” (Fed. R. Bankr. P. 2004). The state-law rules on owners’ rights to company records still govern the other members.

What claims does the company keep against a bankrupt member?

The company may have two claims under Minnesota law: damages for a wrongful bankruptcy dissociation, if that dissociation takes effect, and any debt the member already owed the company. Collecting either one runs through the bankruptcy case, where the member’s discharge may release either claim but does not release the company or anyone else from the company’s own debts.

“A person that wrongfully dissociates as a member is liable to the limited liability company and, subject to section 322C.0901, to the other members for damages caused by the dissociation” (Minn. Stat. § 322C.0601 subd. 3). For a bankruptcy, that claim rests on a dissociation that “occurs before the termination of the company” where “the person is dissociated under section 322C.0602, clause (7), item (i), by becoming a debtor in bankruptcy” (subd. 2). That is the bankruptcy-triggered rule the bankruptcy judge may decline to enforce as written, as described above. Separately, dissociation “does not of itself discharge the person from any debt, obligation, or other liability to the company or the other members that the person incurred while a member” (Minn. Stat. § 322C.0603 subd. 2).

Collection is limited once the case is filed. The stay bars “any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title” (11 U.S.C. § 362(a)(6)), which reaches the debt the member incurred while a member and owed before filing. A chapter 7 discharge reaches “all debts that arose before the date of the order for relief under this chapter,” “whether or not a proof of claim based on any such debt or liability is filed under section 501 of this title” (11 U.S.C. § 727(b)), and a debt “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny” or “for willful and malicious injury by the debtor to another entity or to the property of another entity” is discharged “unless, on request of the creditor to whom such debt is owed, and after notice and a hearing, the court determines such debt to be excepted from discharge” (11 U.S.C. § 523(a)(4), (a)(6), and (c)(1)). I suggest raising both claims in the bankruptcy case early, because recovery from a member in bankruptcy depends on how the bankruptcy case treats each claim. To except a debt from discharge, “a complaint to determine whether a debt is dischargeable under §523(c) must be filed” by the deadline Fed. R. Bankr. P. 4007(c) sets.

The member’s discharge does not shift the company’s debts. Under 11 U.S.C. § 524(e), “discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.” A company loan the bankrupt member guaranteed stays the company’s debt, and any other guarantor stays bound. A member who signed no guarantee has the protection of Minn. Stat. § 322C.0304 subd. 1: company debts “are solely the debts, obligations, or other liabilities of the company” and “do not become the debts, obligations, or other liabilities of a member, manager, or governor solely by reason of the member acting as a member.” The rules on whether a personal guarantee survives bankruptcy apply to the member’s own guarantee.

How is a member’s bankruptcy different from a charging order?

A charging order is a Minnesota court remedy for one judgment creditor of a member, outside bankruptcy: a lien that redirects the member’s distributions to that creditor without a vote. Bankruptcy brings the whole interest into the estate, and the stay halts enforcement of liens against estate property.

“A charging order constitutes a lien on a judgment debtor’s transferable interest and requires the limited liability company to pay over to the person to which the charging order was issued any distribution that would otherwise be paid to the judgment debtor” (Minn. Stat. § 322C.0503 subd. 1). If the court forecloses, “The purchaser at the foreclosure sale obtains only the transferable interest, does not thereby become a member, and is subject to section 322C.0502” (subd. 3). The charging order is “the exclusive remedy by which a person seeking to enforce a judgment against a member or transferee may, in the capacity of judgment creditor, satisfy the judgment from the judgment debtor’s transferable interest” (subd. 7).

Two points matter for co-owners. Before any foreclosure, the company or members whose interests are not charged “may pay to the judgment creditor the full amount due under the judgment and thereby succeed to the rights of the judgment creditor, including the charging order” (subd. 5). That option can keep a co-owner’s interest out of a foreclosure sale while no bankruptcy is pending. Once the member files, the stay bars “any act to create, perfect, or enforce any lien against property of the estate” (11 U.S.C. § 362(a)(4)).

What should an operating agreement say about a member’s bankruptcy?

An operating agreement should state what happens when a member files bankruptcy, because Minnesota lets the agreement govern relations among members, within limits the statute lists, and applies its default rules where the agreement does not otherwise provide. Federal law limits how far a bankruptcy trigger can be enforced, so the agreement should still work if a trigger is not enforced as written.

“Except as otherwise provided in subdivisions 2 and 3, the operating agreement governs” relations among the members, and “To the extent the operating agreement does not otherwise provide for a matter described in subdivision 1, this chapter governs the matter” (Minn. Stat. § 322C.0110 subd. 1 and subd. 2). Subdivision 3 lists terms an agreement cannot change; for example, it may not “unreasonably restrict the duties and rights stated in section 322C.0410,” the records statute. Four provisions address a member’s bankruptcy:

1. Management structure. The agreement should say plainly whether the company is member-managed or manager-managed, because the statute’s bankruptcy dissociation applies only “in a member-managed limited liability company” (Minn. Stat. § 322C.0602).
2. Dissociation events. The agreement may name bankruptcy as “an event stated in the operating agreement as causing the person’s dissociation” (§ 322C.0602, clause (2)), and should say what the member keeps afterward.
3. Purchase rights. A buyout right with a price formula and payment terms should be drafted so it can also be offered to a trustee as a court-approved sale under § 363(b)(1). The drafting choices for these clauses are covered in redemption provisions in an operating agreement.
4. Dissolution. The statute dissolves a company on “an event or circumstance that the operating agreement states causes dissolution” (Minn. Stat. § 322C.0701 subd. 1). I suggest weighing carefully whether one member’s bankruptcy should be such an event, because dissolution ends the business for every owner.

The federal limits described above apply to each of these provisions, so the agreement should not depend on a bankruptcy trigger alone.

Planning for a Co-Owner’s Bankruptcy

When a Minnesota LLC member files bankruptcy, the member’s interest goes to the bankruptcy estate, and in a member-managed company the statute ends the member’s management rights, subject to federal limits a bankruptcy judge applies. The other owners keep the company running, route distributions and records requests through the bankruptcy case, and buy the interest, if they want it, through a court-approved sale. An operating agreement that addresses bankruptcy before anyone is in trouble gives every owner a clearer path. Other disputes among co-owners are covered on the Minnesota business ownership disputes page.

If you want to know how your operating agreement would work if a co-owner files bankruptcy, or what your options are in a co-owner’s pending case, email [email protected] with a brief description of the company and the situation.