Bankruptcy Court Denies Chapter 7 Trustee’s Motion to Sell Debtor’s LLC Interests as Violating Operating Agreements

SUMMARY

In In re Kramer, ___ B.R. ___, 2021 Bankr. LEXIS 358 (Bankr. N.D. Ok.. February 16, 2021) (“Kramer”), relying on a systemic application of Oklahoma contract law and the relevant statute, the United States Bankruptcy Court for the Northern District of Oklahoma (the “Court”) denied the Chapter 7 trustee’s motion to sell the debtor’s interest in a handful of LLCs over the objection of the debtor and the other members because the trustee’s sale violated various terms of the governing operating agreements.  The case can be found here.

Facts

The debtor was an experienced businessman who created LLCs as investment vehicles for customers and family members.  Invariably he was a member, serving as a (or the) managing member and providing other services such as tax and accounting.  In general, the agreements did not provide the debtor with extra compensation for this additional work.  He filed a Chapter 7 case.  The trustee noticed a sale of his interests in the LLCs to creditors after negotiating a deal with a stalking horse purchaser, subject to overbids.  He did not notice other members. 

The debtor and various members of the entities objected on various grounds, principally that the trustee’s sale process and proposed sale terms did not comply with the relevant requirements of the operating agreements as regulated by Oklahoma statutory law governing LLCs.  During the proceedings, the trustee averred that he had intended to sell only the debtor’s economic interests, not his member or partner interests as such, although the notice did not include that limitation.  This he did in response to the objections to try to evade the agreements’ terminology controlling transfers of member interests, believing that the language did not apply to transfers of less than a full unit of ownership.  Upon a methodical reading of the terms of the agreements and applicable statute, the Court sustained the objections. 

Reasoning

The Court began its opinion with a reminder that a bankruptcy estate (and therefore a Chapter 7 trustee) only gets the rights it had under non-bankruptcy law on the eve of filing, subject to any provisions of the Bankruptcy Code that override, suspend, or otherwise modify them.  Thus, the Court explained, to decide the motions and objections it would have to analyze the relevant provisions of the operating agreement and their fate in light of Oklahoma limited liability company statutes and any relevant provisions of the Bankruptcy Code.  It took pains to do this on an LLC-by LLC basis.  In deciding the motion, the judge accepted the trustee’s last-minute claim that he only intended to sell the debtor’s distribution rights in the entities, not the full set of rights represented by each unit that included such matters as participation in the LLC’s affairs and management.

Rather than tracing the Court’s thorough analysis of the fate of each LLC, this report will review the Court’s resulting findings and conclusions at a general level.  As presaged above, the key issue focused on the agreements’ various limitations on the sale of a member’s interest in the LLC.  The agreements all had various prohibitions and procedures for the sale of an “interest” in the LLC.  Here are some examples.  All required notice to the other members.  Some included a right of first refusal in favor of other members or the LLC itself for a bona fide offer, with various procedures to be followed to honor that right.  Those involving family essentially limited any disposition in any case to other family or family-related entities.  The trustee evidently thought none of these would apply to a transfer of the economic interest of the debtor only.

The Court disagreed.  It focused on such language in the agreements’ provisions regarding limitations on transfer that refer to all or any part of an interest in the LLC as subject to the limiting terms.  A typical formulation of this formula is, “all or a portion of his Units, or any interest therein.”  (Emphasis added.)  This, the Court concluded, meant that the any proposed sale of the economic interest alone triggered the regulations.  The Court added on this score that it was clear from the debtor’s role in the LLCs that the members relied on his expertise and skills.  Since it was clear the debtor would not continue to provide extra services, for which he was not otherwise compensated, if he could not benefit economically from an LLC because his economic interest was transferred with no consideration to him, the Court found an additional reason for interpreting the term “interest” to include sub-interests such as his economic interests.  In regard to one provision of Oklahoma LLC statute that the trustee said overrode the relevant provisions of the agreements, the Court pointed out that the statute by it terms applied only if an agreement was silent on the subject; far from being silent, the agreements were quite specific in governing proposed sales of an interest in the LLC. 

The only argument the trustee made that the Court sustained was that the clause of one agreement – that triggered a dissolution of the LLC itself upon the bankruptcy of any member – was an “ipso fact” clause ruled out by the Bankruptcy Code’s prohibition against operation of such clauses.  Even then, the trustee’s motion as to that particular LLC failed because it ran afoul of the agreement’s other regulation of the sale interests that the trustee had failed to respect. 

Authors’ Comment

The decision is sound.  And its analysis is a model of care and a lesson in contract law, as well as the application of a statue to a contract.  By contrast, it appears that the trustee simply failed to do his homework, even to the point of having to orally amend his motion at the hearing to try (unsuccessfully) to evade some of the objections.  Of course, the outcome does not mean the trustee cannot try again with proceedings that comply with the agreements.  But that choice seems unlikely given that the sale price in the trustee’s motion was only between $5,000 and$10,000, and the cost of a second motion that relies on first abiding by the agreements’ relevant provisions would probably not be worth the reward even if granted.  Instead, the trustee may be better off trying to “sell” the interests back to the debtor, who evidently had expressed some interest, by abandoning them for an agreed-upon price.  The alternative is that the trustee will be unable to sell them at all, in which event by operation of bankruptcy law they will revert to the debtor for free.  One final point is that Kramer is a reminder that even though the Bankruptcy Code contains powerful provisions to override or modify state law rights, it is not license for the estate representative; it always pays to attend carefully to the legal background. 

The Commercial Finance Newsletter is written by an ad hoc group of the California Lawyers Association (CLA) Business Law Section.  These materials were authored by Adam A. Lewis, Senior Counsel, Morrison & Foerster LLC, a member of the ad hoc group, with editorial assistance by Meredith Jury, (bankruptcy judge, C.D. Cal. (Ret.)), a member of the ad hoc group.  The opinions expressed herein are solely those of the author.  Thomson Reuters holds the copyright to these materials and has permitted the Commercial Transactions Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.

This ebulletin was prepared by Walter K. Oetzell, Walter K. Oetzell, APC, wkoetzell@oetzelllaw.com.