LLC Protection in Bankruptcy

I have commented previously that limited liability companies probably do would not have asset protection benefit in a bankruptcy proceeding. My reasoning was that the LLC protects assets by virtue of the limited creditor remedy of a charging lien provided in Florida statutes, but that in bankruptcy the trustee would claim that he is not limited by the state’s creditor procedures and has title to all of the debtor’s interest in a LLC. A bankruptcy court decision earlier this year in Arizona analyzed a trustee’s rights to a debtors membership interest. The case was In re Ehmann decided January 13, 2005.

The bankruptcy judge explained that when a debtor’s interest in an LLC or partnership is in the nature of an executory contract that the Chapter 7 trustee is limited by rights of creditors provided in state statutes. An executory contract is a legal relationship where both the member and the LLC have reciprocal obligations.

When the LLC member has no material duties to perform in consideration for his economic membership interest the court said that the Trustee’s rights are not limited by the state’s charging lien remedies so that the membership interest is included in the bankruptcy estate. An example given of an executory relationship between an LLC and its debtor/member is when the member is obligated to make capital contributions. Based on this one bankruptcy court analysis an LLC operating agreement that makes the members liable for capital contributions would more likely be deemed an executory contract and might be protected in a member’s Chapter 7 bankruptcy. The debtor would have a better case if the manager did in fact require members’ capital contributions. I am not aware of any decisions on this issue by a Florida bankruptcy court.

 

Last updated on May 22, 2020

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