The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), analyzing a recent decision of interest:
In an unpublished but analytical opinion, the Bankruptcy Appellate Panel for the Tenth Circuit (the BAP) recently affirmed a bankruptcy court decision which held that under the Limited Liability Company Act of Oklahoma (the Act) a chapter 7 trustee may not sell or assign a debtor member’s purely economic interests in Limited Liability Companies(“LLCs”) without complying with restrictions on such transfers contained in the LLCs’ Operating Agreements. Malloy v Kramer (In re Kramer), 2022 WL 17176411 (10th Cir. BAP Nov. 23, 2022).
To view the opinion, click here.
Robert Kramer (the Debtor) held membership interests in several LLCs organized under the Act. In 2019, after extensive litigation, Trak-1 Technology obtain a $3.2 million judgment against the Debtor, causing him to file a chapter 7 case in the Northern District of Oklahoma. Patrick Malloy, the chapter 7 trustee (the Trustee), with support from Trak-1, filed a motion to sell personal property of the estate, which consisted of the Debtor’s capital interests (defined below) in the LLCs in which he was a member. Several parties, primarily other members of the LLCs who by name appeared to be relatives, objected, arguing that any such sale must comply with the transfer restrictions found in the Operating Agreement of the various LLCs. In general, these restrictions provided that no sale of a membership interest could occur without the consent of the other members.
The Trustee responded to these objections, asserting that since he was only selling the Debtor’s economic interest, the transfer restrictions were not enforceable under both state and bankruptcy law. The bankruptcy court agreed with the objecting parties, concluding that the restrictions applied to membership and capital interests alike. Because consent from the other members was lacking, it denied the motion to sell.
The Trustee, joined by Trak-1, appealed to the BAP, which affirmed.
Applying the de novo standard of review since the governing questions were all question of law, the BAP determined it must resolve three issues: (1) whether the bankruptcy court correctly interpreted the Act; (2) whether the bankruptcy court correctly interpreted the Operating Agreements; and (3) whether the transfer restrictions were enforceable against the Trustee under bankruptcy law. It answered all three queries in the affirmative.
First, the BAP noted that although LLC bankruptcy case law often referred to a member’s two-fold interests in an LLC as an “economic” interest and a “management” interest, the Act specifically defined the economic interest which the Trustee desired to sell as a “capital” interest: “the fair market value as of the date contributed of a member’s capital contribution as adjusted for any additional capital contributions or withdrawals, a person’s share of the profits and losses of a limited liability company and a person’s right to receive distributions of the limited liability company’s assets.” The Act stated that unless an Operating Agreement provided otherwise, “…a member may assign the capital interest associated with a membership interest in whole or in part.” Okla. Stat Ann. § 2033 (A)(1). The BAP analyzed the syntax of the statute and concluded that it allowed the Operating Agreements to restrict all transfers, including of the capital interest, and that the subject Operating Agreements had done just that.
The BAP then considered the scant Oklahoma case law to determine whether such restriction on transfer was enforceable. Rejecting dicta in the one frequently cited case on such restrictions, Southlake Equipment Co. v. Henson Gravel & Sand, LLC, 313 P. 3d 289 (Okla. Civ. App. 2013), the BAP independently analyzed whether the language used in the Operating Agreements to restrict transfers – “the members’ abilities to transfer all or a portion of, or any interest in, their ownership interests” – applied to sales or assignments of solely the capital interests in light of the statutory language of the Act. Again, it concurred with the objecting members that the intent of the Operating Agreements was to override the Act and restrict any transfer of any part of a member’s interest.
Finally, the BAP entertained the Trustee’s argument that § 541(c)(1) of the Bankruptcy Code prevented enforcement of the transfer restrictions against the estate. Section 541(c)(1) provides that a debtor’s property interests become property of the estate notwithstanding any provision in an agreement or applicable nonbankruptcy law that (A) “restricts or conditions transfer of such interest by the debtor,” or (B) that is conditioned on the insolvency of a debtor and “effect[s] a forfeiture, modification or termination of the debtor’s interest in property.” i.e., an ipso facto clause. The BAP concluded that neither part of § 541(c)(1) was called into play here, because the capital interests had becomepart of the Debtor’s estate, so subsection (A) was satisfied, and there was no forfeiture due to the bankruptcy petition. Therefore, the BAP upheld the bankruptcy court ruling, imposing the transfer restrictions.
Two factors inform my comments. First, Oklahoma has not adopted the Uniform Limited Liability Company Act, which about fifty percent of the states have enacted, so this opinion may have limited impact in many states. Second, while a sitting judge, I was on a Federal Judicial Center panel (the FJC conducts annual educational programs for all bankruptcy judges) in 2017-18 about LLCs in bankruptcy proceedings. My topic was what happened in a chapter 7 when a debtor held membership interests in LLCs. Of particular interest to me was how could a trustee liquidate/monetize such membership interests for distribution to creditors. I found the case law all over the map, often depending on whether the trustee approached those interests as property of the estate or instead stood in the shoes of a hypothetical lien creditor. Despite the variation in approaches, on the whole the cases supported a trustee’s sale of the debtor’s economic interest but rarely allowed the trustee to exercise the management or control interest. Frequently the cases analyzed the impact of § 541(c)(1) and concluded that the economic interests did not become “meaningful” (my word) assets of the estate, as required by subsection (A), unless the trustee could assign or transfer them for a monetary value. Therefore, they concluded that the Bankruptcy Code overrode transfer restrictions found in operating agreements. In a nutshell, they arrived at a different conclusion than the BAP here.
That said, those cases lacked precedential value and the BAP’s analysis here, in light ofthe language in the Oklahoma statute and the relevant Operating Agreements, is persuasive. Note, however, that the BAP chose not to publish, so one wonders about the breadth of the impact of its determination. Either way, this is a discouraging outcome for a trustee and the estate’s creditors. What happens when a debtor has substantial holdings in LLCs of great value and the trustee cannot touch them? Does he get away Scot free, entitled to a bankruptcy discharge while (perhaps) family members or close friends prevent liquidation of valuable assets? One remedy would be the trustee exercising his hypothetical lien creditor rights and obtaining a charging order against any distribution. But that remedy might prove fruitless if those (perhaps) family members decide that no distributions will be made for multiple years. I do not see an easy answer to this conundrum without legislative intervention or some creative approaches that other lawyers may offer.
This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.