Charging Order Vs Bankruptcy

The primary purpose of bankruptcy law is not to protect the debtor, but instead is to marshal the debtor’s assets for the benefit of creditors. When a creditor seeks a charging order against your ownership interest in an LLC (everything discussed below still applies to limited partnerships as well), such efforts are governed by state law. However, when you file for bankruptcy, either voluntarily or involuntarily, federal law takes over.

Many people are under the false assumption that if they form LLC in a state that restricts a creditor’s remedy to a charging order, then they need not worry about whether a creditor can force a dissolution or otherwise reach LLC assets. However, if a debtor is driven or forced into bankruptcy, the protections of state law may wither. To clarify, state law determines the nature of the bankrupt debtor’s membership or partnership interest, but federal law determines the extent to which that ownership interest becomes part of the bankruptcy estate.

Absent substantial duties to the LLC, expect a debtor’s entire LLC interest – including the right to participate in management and the right to vote for or otherwise seek dissolution – to be part of the bankruptcy estate.

Once federal bankruptcy law has been applied to determine the general extent of the bankruptcy trustee’s interest in the LLC (i.e., whether the trustee steps into the shoes of the debtor or is merely treated as an assignee), state law and the LLC operating agreement (or partnership agreement) determine what rights the bankruptcy trustee has.

In order to avoid giving a bankruptcy trustee the right to force distributions or to dissolve and liquidate an LLC, one must choose state law wisely and carefully draft LLC operating agreements. Whether or not the bankruptcy trustee is subject to state and contract law restrictions on the trustee’s rights and powers turns on whether the operating agreement is determined to be “executory” or “non-executory.”

The classic definition of an executory contract is one in which “the obligations of both parties are so far unperformed that the failure of either party to complete performance would constitute a material breach and thus excuse the performance of the other.”

If your operating agreement is not an executory contract, the bankrupt trustee’s rights to the interest in the LLC are governed by the general provisions of 11 U.S.C. §541(c). Section 541(c)(1) provides that an interest of the debtor becomes property of the bankruptcy estate notwithstanding any agreement or applicable law that would otherwise restrict or condition transfer of such interest by the debtor. All limitations in the LLC’s operating agreement and all provisions of state law that restrict or condition the transfer of a debtor membership interest in the LLC are inapplicable pursuant to §541(c)(1). Accordingly, the bankruptcy trustee has all of the rights and powers with respect to the LLC that the debtor-member held as of the filing of bankruptcy and is not limited solely to a charging order, nor is the trustee prohibited from reviewing the books and records of the LLC or voting as a member of the LLC. The key asset protection features of an LLC are sterilized if the operating agreement of the LLC is not an executory contract.

If the LLC’s operating agreement is an executory contract, the bankruptcy trustee’s rights to the interest in the LLC are governed by the general provisions of 11 U.S.C. §§365(c) and (e). Although there is some judicial ambiguity, §§365(c)(1) and 365(e)(2) allow for the enforcement of state and contract law restrictions upon a bankruptcy trustee’s rights to a bankrupt member’s interest in the LLC. In other words, you want the LLC operating agreement to constitute an executory contract so that the asset protection terms will likely be respected in the bankruptcy of one of its members.

Several recent bankruptcy cases have upheld the notion that if operating agreement is not an executory contract under federal bankruptcy law, then the asset protection features generally applicable to a bankrupt member’s interest in the LLC under state and contract law will not apply to the bankrupt member’s bankruptcy trustee. In order to ensure that the LLC operating agreement is an executory contract and that such asset protection features continue to apply in a bankrupt member’s bankruptcy, certain obligations need to be imposed upon such bankrupt member and incorporated into the LLC operating agreement.

The courts have indicated that some of the key factors they look for in determining whether an LLC operating agreement is executory or not include, but are not limited to: the purpose of the LLC; the requirement of members to make future capital contributions; the requirement that members be involved in the management of the LLC; and the imposition of fiduciary duties upon the members.

If an operating agreement is determined to be executory, it does not mean that the debtor’s ownership interest is automatically excluded. It just means that the bankruptcy trustee, subject to the bankruptcy courts approval, may assume or reject the executory contract. If the trustee assumes the executory contract operating agreement, it means that the trustee steps into the debtor-member’s shoes and essentially replaces the debtor as an LLC member. If the trustee rejects it, then the LLC ownership interest is excluded from the bankruptcy estate. So, it is important to make the assumption of the operating agreement as unattractive as possible. With that in mind, an LLC operating agreement should include the following:

A provision setting forth the business purpose of the LLC so that the bankruptcy court will not frustrate such purpose and adversely affect the rights of the non-bankrupt members by disregarding the operating agreement and state limited liability company laws.

A statement that the parties desire and agree that the operating agreement constitute an executory contract under 11 U.S.C. §365, with a summary of each duty imposed upon a member to create the executory contract.

A duty to make future capital contributions by each member.

An obligation for each member to comply with certain fiduciary duties owed to the other members and the LLC.

An obligation that each member be involved in the management of the LLC and attend regular member meetings.

To summarize, the trick when drafting LLC operating agreements to not include duties that one would not want a creditor performing if the agreement nonetheless was found to be non-executory (such as management duties relating to LLC assets that could put assets in the hands of the creditor), and/or to include duties that may be to the economic disadvantage of the creditor (such as mandatory capital call provisions).