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LLC Interests and a Member’s Bankruptcy, Part II

[The other articles in this seven-part series are here:  Part I, Part III, Part IV, Part V, Part VI, Part VII.]

In re Lee, 524 B.R. 798 (Bankr. S.D.Ind. 2015) involved an Indiana limited liability company with five members, one of whom, Lester Lee, held 51 of the 101 votes allocated to the members and served as the sole manager of the LLC.  Although Lester had no right to receive distributions from the company, he was entitled to compensation for his services as manager and, like the other members, he held rights to buy the interests of other members in certain circumstances.

After Lester filed for bankruptcy protection, the trustee sought a determination from the bankruptcy court that the bankruptcy estate held all of Lester’s rights in the LLC, both economic and noneconomic, including the right to cast his 51 votes as a member. The Bankruptcy Court agreed.

The starting point of the court’s analysis is Section 541(a) of the Bankruptcy code, which provides that, upon the filing of a bankruptcy petition, almost all of a debtor’s property immediately becomes “property of the estate.”

Whether an interest claimed by the debtor is “property of the estate” is a federal question to be decided by federal law; however, courts must look to state law to determine whether and to what extent the debtor has any legal or equitable interests in property as of the commencement of the case. Butner v. United States, 440 U.S. 48, 55, 99 S.Ct. 914, 918, 59 L.Ed.2d 136 (1979); Matter of Jones, 768 F.2d 923, 927 (7th Cir.1985).

To determine whether Debtor’s voting rights in the Lee Group are property of the estate, the Court looks to the express terms of the Operating Agreement and to relevant sections of the Indiana Business Flexibility Act, Indiana Code §§ 23-18-1-1 to 23-18-13-1 (the “Act”).

Indiana Code § 23-18-1-5 defines “member” as “a person admitted to membership in a limited liability company under IC 23-18-6-1 and as to whom an event of dissociation has not occurred.” Indiana Code § 23-18-6-1, in turn, provides in relevant part that “a person may become a member in a limited liability company . . . in the case of a person acquiring an interest directly from the limited liability company, upon compliance with the operating agreement or if the operating agreement does not provide in writing, upon the written consent of all members.”

Relying on the LLC’s operating agreement, the court concluded that Lester was a member of the LLC and that his voting rights were incidental to his membership.

For the final step in its analysis, the court cited the decisions of several Bankruptcy Courts holding that all of a debtor’s rights in a limited liability company, both economic and noneconomic, become property of the estate when the member files a bankruptcy petition.

The LLC appealed the decision of the Bankruptcy Court to the District Court, primarily on the grounds that the Bankruptcy Court erred in concluding that Lester was a member of the LLC.  In Lee Group Holding Co. v. Walro, the District Court affirmed the decision of the Bankruptcy Court without revisiting the question of whether all of Lester’s rights, both economic and noneconomic, including his voting rights, were property of the estate. Thus the trustee acquired a majority of the voting rights of LLC members and, depending on the other terms of the operating agreement, probably the power to control the LLC and make significant decisions, perhaps even to dissolve the LLC, over the objections of the other members.

However, in the author’ view, whether Lester’s noneconomic rights were property of the estate should not have been the end of the analysis.  We’ll take that up in Part IV, after we take a closer look in Part III at the nature of the rights a member may hold in an Indiana LLC.

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