29 Apr How to Bullet Proof Your LLC from the Bankruptcy of an LLC Member

Last week we began a series of blogs concerning limited liability companies—why you want them, how you form them, and how to make your LLC bullet proof.  But even taking the most careful steps in setting up your LLC cannot prevent the unplanned—being sued in expensive litigation, stock market crashes, large medical expenses, the list goes on.  What happens when you or one of the members of your LLC has to file for bankruptcy?  How do you keep your LLC protected from the bankruptcy of an LLC member, and the trustee who may seek to recover assets from the LLC?

Bankruptcy of an LLC Member

The possibility that you or a member of your LLC might end up in bankruptcy was probably an afterthought when you formed your LLC.  However, the bankruptcy of an LLC member can wreak havoc on your LLC, as the bankruptcy could result in (1) handing over the management of your LLC to a Chapter 7 trustee; (2) a sale of the bankrupt member’s interests to a third party; and/or (3) a judicial dissolution of the LLC.  The bankruptcy of an LLC member could not only disrupt business operations but also result in costly litigation.  What can you and your LLC do to prevent these types of issues?  Include provisions in your LLC’s operating agreement that prevent future chaos.

What Provisions in an Operating Agreement Can Protect Your LLC From the Bankruptcy of an LLC Member?

There are 4 four key provisions that you and your attorney should include in the operating agreement to make it bullet proof in an LLC member’s bankruptcy proceeding:

Ensure That Your Operating Agreement Is an “Executory Contract” Under § 365

Making sure that your LLC’s operating agreement an “executory contract” in bankruptcy is probably the most important part of bulletproofing your LLC from the bankruptcy of an LLC member.  An “executory contract” is a contract where both parties still need to perform under the contract and the “obligation of both the [debtor] and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.”  This means the debtor LLC member must have substantial, current, unperformed obligations if an operating agreement is to be treated as an executory contract.  If this is the case, the non-debtor LLC members are excused from “accepting performance” from a third party, such as a bankruptcy trustee, allowing the trustee to have an economic interest in the company, but no management or voting rights.  This is critical because an LLC interest with no voting rights is less appealing to a bankruptcy trustee trying to maximize profits for the bankruptcy estate as it prevents the trustee from selling the LLC. 

The best way to phrase this provision in the operating agreement is to state that the “members’ intent is that the operating agreement be deemed an executory contract.”  Also, courts have found that the following obligations are “material” for purposes of determining whether a breach of this obligation by one member would excuse the performance of the other, non-breaching members:

• Obligation to make cash contribution or respond to capital calls (without veto right by member)
• Obligation to provide personal services
• Restriction from engaging in unauthorized transfer of membership interest
• Non-compete and/or non-disclosure obligations
• Affirmative restriction from voluntarily withdrawing as member
• Guarantee of LLC’s debt

So including any of these provisions in your operating agreement as member obligations is helpful for purposes of establishing the operating agreement as an executory contract.

Ensure That the Operating Agreement and Any Other Formation Documents are “Integrated”

The second provision that should be included in your operating agreement is a provision that ensures that the operating agreement and any other LLC formation documents, like capital call agreements, options or personal service agreements, are “integrated”.  When dealing with a bankruptcy, integrated documents are beneficial because they ensure that if a member files bankruptcy, the bankruptcy trustee cannot cherry pick the favorable contracts of the LLC and reject the less favorable ones, which makes it less likely that the trustee will assume any of the LLC’s contracts.

Include a Right of First Refusal or Other Option to Purchase the Estate’s Interest Upon a Proposed Sale

The third provision that you should include in your operating agreement to ensure it is bulletproof if an LLC member files for bankruptcy is a provision detailing the right of first refusal or other option to purchase in the event of a sale or transfer, including a sale in bankruptcy.  Including the right of first refusal in your operating agreement also makes it more likely that your operating agreement will be treated like an executory contract, allowing it to be rejected by the non-bankrupt LLC members.  Thus the right of first refusal is a critical tool for non-debtor members to maintain control of the LLC, regardless of whether the operating agreement is executory.  As long as you and your attorney do not tie the right of first refusal to the bankruptcy filing; the LLC member debtor’s financial condition; or the appointment of a trustee, the court is likely to uphold the right of first refusal.

Include in Your Operating Agreement That a Material Breach of the Operating Agreement Makes a Member a Mere Assignee Without Voting Rights

The fourth provision for your LLC should be narrowly tailored to provide a potential alternative to you and your LLC for preventing a Chapter 7 trustee from obtaining non-economic rights such as management or voting rights.  The following revision might prevent a bankruptcy trustee from obtaining non-economic rights:

“A member shall cease to be a member of the Company and that member shall attain the status of mere assignee under Section __ of this Operating Agreement upon the occurrence of one or more of the following events: …. (a) Material breach of this Operating Agreement….” 

This provision is helpful because an ultimate rejection of an LLC contract under this provision does not terminate the contract itself but rather frees the estate from any obligations under the contract, and the operating agreement would still govern the Chapter 7 trustee’s rights under it, if any.

By employing knowledge about bankruptcy law and adhering to the above drafting tips,   Edwards Law can help you revise your LLC’s operating agreement to make it bullet proof in the bankruptcy of an LLC member.  Call Edwards Law today to get started on the drafting process.