Dear members of the constituency list of the Commercial Transactions Committee:
The following is an update analyzing a recent case of interest.
A Bankruptcy Court in the Eastern District of Virginia (the Court) recently ruled that a provision under Virginia law which dissociates a member of a limited liability company upon the filing of a bankruptcy petition, thereby terminating that member’s non-economic/management interests in the LLC, was unenforceable as a violation of Bankruptcy Code § 541(c)(1) because it effects a “forfeiture, modification, or termination of the debtor’s interest in property.” King v. Johnson (In re Johnson), 2021 WL 5496731 (Bankr. E.D. Va. Nov. 22, 2021). To view the opinion, a copy is available on the court’s website.
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Debtors Jerome and Michelle Johnson (debtors or, individually, Jerome) were members of Legacy Wealth Properties, LLC (Legacy or the LLC), with a 52% and 24% membership interest, respectively. The debtors’ daughters held the other 24% interest. Legacy owned real property in Ford, Virginia (the Property). In October 2016 the four members executed a Consent to Action (the Consent), in which they agreed to transfer 100% of the Property to Mary Ellis Johnson. The LLC did not transfer the Property at that time and Legacy continued to own the Property until the debtors filed a chapter 7 petition in July 2019. Donald F King was appointed the chapter 7 trustee (the Trustee). In July 2021, while the chapter 7 was still pending, Jerome, acting as the managing member of Legacy, transferred title to the Property to Mary E. Johnson.
The Trustee filed an adversary proceeding against Legacy, Mary E. Johnson, and the daughters, asserting counts for fraudulent transfers of the Property under § 548(a)(1), fraudulent transfers related to the Consent, sale of a co-owner’s interest, and dissolution of the LLC. The daughters and Legacy filed a motion to dismiss under Rule 12(b)(6) as to all claims. The Court granted in part and denied in part the motion to dismiss.
The Court easily disposed of the fraudulent transfer claims pertaining to the Property, observing that the Property belonged to the LLC, was never the debtors’ property, and was not property of the estate. Since § 548(a)(1) allows a trustee to avoid “any transfer… of an interest of the debtor in property,” it could not be used to recover Legacy’s property. Similarly, the sale of co-owner’s interest count was stricken since only Legacy owned the property on the petition date. The Court allowed the fraudulent transfer claim regarding the Consent to stand, since it purported to disenfranchise the debtors from their membership interests and on its face was a transfer which might be avoided.
The more controversial ruling pertained to the Trustee’s claim to dissolve the LLC. Under Virginia law, upon application by a member, the state court may order a dissolution of an LLC when it is not practicable to carry on the business in conformity with the articles of organization and operating agreement. The Trustee sought to assert this right, exercising the members’ rights of the debtors. Virginia law also has a provision whereby a member of an LLC is dissociated upon the filing of a bankruptcy petition, which leaves the member only with the rights of an assignee. An assignee has rights to receive a share of profits (the economic interest) but is precluded from participating in the management or affairs of the LLC (the non-economic interest). If enforceable in bankruptcy, this provision would prevent the Trustee from dissolving Legacy.
As the Court noted, whether a state law provision which would terminate an LLC member’s non-economic interest is enforceable in a bankruptcy proceeding is an issue about which courts disagree, including bankruptcy courts in Virginia. The controversy arises regarding the applicability of § 541(c)(1), which is construed to find ipso facto clauses unenforceable. Subsection (B) of this section says in essence that a state law that is “conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, ….that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property” is inapplicable when referring to property of the estate in a bankruptcy case and thereby unenforceable. The Court cited two conflicting Virginia bankruptcy court decisions, one finding the Virginia dissociation statute was not an improper ipso facto clause and therefore could be used to cut off an LLC member’s non-economic interest and the other concluding that dissociation would be a violation of § 541(c)(1), preserving the non-economic interest as property of the estate.
The Court agreed with the latter and ruled that the dissociation provision was an invalid ipso facto clause and that the Trustee retained the power to dissolve the LLC. It rested its conclusion on the fact that § 541(c)(1) does not distinguish between economic and non-economic interests. The term “an interest of the debtor is property” has been broadly construed in case law. Since Congress could have limited the application of § 541(c)(1) to only economic interests and it chose not to do so, the conclusion that it applied to any interest, including a non-economic interest, was sound. Moreover, the Court cited authorities as high as the Supreme Court which treated non-economic rights as valuable rights of a debtor and an estate. The Supreme Court said in Butner v. United States, 99 S. Ct. 914 (1979) that bankruptcy courts must look to state law to determine property of the estate “unless some federal interest requires a different result.” Id. at 918. The Court here found that there is a federal bankruptcy interest expressed in § 541(c)(1) which takes priority over state law.
While sitting as an active bankruptcy judge, I was on a panel for our Federal Judicial Center’s training of bankruptcy judges which focused on the intersection of LLC’s and bankruptcy. My topic was what happens when a member of an LLC files bankruptcy: what membership rights come into the estate and how does the trustee go about monetizing them. In preparation, I read every case in the country I could find on the topic. Almost all were written by bankruptcy courts, with almost no appellate authority at any level. Not surprisingly, I found enormous disparity among the conclusions. Often I concluded that how a court ruled depended largely on how the parties posed the arguments to the court, whether asserting the trustee’s property rights or hypothetical lien creditor rights. Whether a trustee could exercise management rights of a debtor member was one of those issues which divided the courts. Some exercised § 541(c)(1) to obviate state laws which almost uniformly dissociate a bankrupt member, finding them improper ipso facto clauses; some allowed that restriction to stand. We are all waiting for some appellate authority on this issue. For one, I think the Court’s reasoning here is persuasive. A property interest is not limited in § 541(c)(1) and the broad definition of property of the estate seems to dictate that non-economic interests cannot be forfeited.
One final note. Our panel also repeated the program for practicing attorneys in the Bay Area. My advice to them: be creative and try any argument that will bolster your client’s position. It is unlikely you will find any appellate authority against the positions you are arguing, no matter where in the country you practice.
The Commercial Finance Newsletter is written by an ad hoc group of the California Lawyers Association (CLA) Business Law Section. This review was written by the Hon. Meredith Jury (U. S. Bankruptcy Judge, CD CA, 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, firstname.lastname@example.org.