LLC Member Interests and Bankruptcy: Courts Begin to Sort Things Out

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1 FALL 2003 FALL 2003 In this Alert you ll find articles and opinions of interest as well as news about the practice and the firm. Please us with any questions or suggestions on future topics: LLC Member Interests and Bankruptcy: Courts Begin to Sort Things Out The LLC, taking some of its attributes from partnerships and other attributes from corporations, has become an entity of choice in business ventures. Equity owners favor the partnership-like flow-through tax treatment. They also like the corporate-like limited liability. As the LLC is a relatively new entity, however, there are few bankruptcy court decisions dealing with how member interests in an LLC will be affected when a member becomes the subject of a bankruptcy case. A few recent bankruptcy court decisions allow us a peek at where things appear to be headed. In the corporate context, an equity interest is represented by a stock certificate. When a stockholder files a bankruptcy petition, the equity represented by the stock certificate(s) belongs to the bankruptcy estate which is created upon the filing of the bankruptcy case and is composed of all of the debtor s interests in real and personal property. The estate, whether managed by a trustee or a debtor in possession, is generally free to transfer the stock certificate(s) to a third party as long as authority for the sale is obtained after notice in accordance with Bankruptcy Code procedures. If there is a restriction on transfer of the shares, the restriction is usually contained in a shareholders agreement. Those agreements are generally found to be executory contracts under the Bankruptcy Code and capable of being rejected by the debtor in possession or trustee. Once rejected, they are no longer enforceable and do not restrict the transfer. In the context of an LLC, however, partnership concepts rather than those of corporate law appear to dominate the legal landscape. State statutes applicable to the creation of an LLC in that jurisdiction are likely to restrict the ability of a member to transfer that member s interest in the LLC without the consent of the other members, unless the members have provided otherwise in the operating agreement. The operating agreement could contain a variety of restrictions on transfer of the member interest. It might also provide to the remaining members of the LLC a right of first refusal on the proposed sale of the member s interest. 1 of 7

2 A bankruptcy court asked to rule on the transfer of a debtor s member interest in an LLC will probably begin with a review of the state statute where the LLC was organized. If the state statute requires the non-debtor member of an LLC to consent to a transfer of the debtor s LLC member interest, and the operating agreement does not provide otherwise, the bankruptcy court is likely to find that Section 365(c)(1) allows the non-debtor LLC members to block the transfer of management and operating rights from the debtor to a new party. However, bankruptcy courts will undoubtedly have a problem with any restriction on the transfer of the debtor s economic interest in the LLC. The court will see the debtor s member interest in the LLC as composed of two severable parts. First is the economic interest, separate and distinct from the ability as a member to participate in the management and operation of the LLC. If the debtor s bankruptcy estate cannot realize the value of the economic interest of the debtor in the LLC, it would mean a forfeiture of the debtor s economic interest in favor of the other members of the LLC. Those non-debtor members in the LLC would become the only ones with an ability to buy the debtor s member interest, since their ability to withhold their consent to any transfer would eliminate the possibility of selling to any other party. Bidding on such an interest would be effectively chilled. Bankruptcy courts, often seeing their mission as assisting creditors in realizing the value of the debtor s interest in property owned as of the beginning of the bankruptcy case, have wrestled with and usually rejected the enforceability of such restrictions on the transfer of an economic interest relying on Section 365(f) of the Bankruptcy Code and the Supremacy Clause of The Constitution of the United States. Accordingly, bankruptcy courts will allow the transfer of an economic interest of the debtor in an LLC while bifurcating and restricting transfer of the member s ability to participate in the management of the LLC. Therefore, when establishing an LLC, it is prudent to include in the operating agreement provisions, authorized by state statute, requiring the consent of the remaining members when one member seeks to transfer a member interest. In the context of the transfer of the economic interest of a debtor member in the LLC, bankruptcy courts also have to wrestle with rights of first refusal on the transfer of a member s interest that might be provided exclusively to other members in the LLC s operating agreement. This type of restriction, while allowed by statute, is most often found in the operating agreement. Since rights of first refusal can also be expected to have a negative impact on the sale price of a debtor s member interest in an LLC, it is realistic to expect that a bankruptcy court will be influenced to find a way to avoid enforcing the right of first refusal. However, the path to doing so is not necessarily clear. If the member interest can be transferred without the operating agreement, and the operating agreement is rejected, then the terms in the operating agreement that put any restrictions on transfer of the member interest, including a right of first refusal, will not be enforceable. On the other hand, if the member interest can only be transferred with the assumption and assignment of the operating agreement, Section 365(f) of the Bankruptcy Code can be the means to strike the right of first refusal because it prohibits, restricts, or conditions the assignment. However, a recent decision in a Chapter 11 case in Delaware resulted in the bankruptcy court permitting the transfer of the debtor s economic interest in the LLC, but enforcing the non-debtor members right of first refusal. While it appears prudent to include a right of first refusal in the operating agreement of the LLC, it will not necessarily insure that a bankruptcy court will enforce the provision. The bankruptcy court will be concerned that the right of first refusal might chill the bidding on a transfer of the economic interest. 2 of 7

3 All of this loses any relevancy when we are dealing with a single-member LLC. Since the debtor s interest in the LLC passes to the debtor in possession or trustee upon the filing of the bankruptcy case by operation of law, the debtor in possession or trustee obtains the ability to consent to a transfer of that interest. A recent decision from the United States Bankruptcy Court in Colorado, In re Ashley Albright, case number ABC (Bankr. D. Co. 2003), makes it clear that the trustee, as the sole member of the LLC, has the ability to provide consent to the transfer of a member interest in a single-member LLC and can otherwise exercise management control over the LLC. The trustee can either transfer the member interest or just liquidate the assets of the LLC and realize their value as the sole member. The Ashley Albright court s reasoning is persuasive, and there is no reason to believe that a single-member LLC is an effective way to prevent the sole member s interest from being transferred in a bankruptcy case. In an interesting footnote in the Ashley Albright case, the court puts out a warning to those who try to set up peppercorn co-members of an LLC in an attempt to avoid the problem presented by a single-member LLC in bankruptcy. These sham co-members, according to the court, will likely not be effective because the Bankruptcy Code s avoiding powers for fraudulent transfer provisions should be enough to overcome the sham. Whether that warning is valid or not, it would make sense for an entrepreneur contemplating a single member LLC to strongly consider bringing in at least one other member with more than a token involvement in order to gain the various protections that will be afforded to nondebtor members should the entrepreneur later need the protections of a bankruptcy court. Tolling Agreements in Preference Actions An Explanation and a Guide Preference litigation is a pervasive, perennial problem for creditors who extend credit to distressed businesses. In addition to not getting paid for goods and services advanced to businesses who ultimately seek bankruptcy relief, creditors also frequently become embroiled in litigation to recover these otherwise perfectly proper and lawful pre-bankruptcy transfers. Usually, preference litigation is prefaced with a written demand from a debtor s attorney for the immediate return of specific payments made by the debtor during the 90-day period prior to the bankruptcy filing, the so-called preference period. Lawsuits to recover the payments may soon follow the demands if preference claims are not promptly honored or compromised. Often the most cost-effective way of resolving disputes concerning whether pre-bankruptcy transfers are recoverable as preferences is to settle them before litigation is commenced in bankruptcy court. Responding to a debtor s complaint and discovery requests and engaging in motion practice and trial preparation is simply a needless waste of resources if the dispute can be resolved informally. Creditors who promptly marshal the facts and evidence that support their defenses to preference recovery and make realistic settlement offers are frequently able to obtain favorable compromises and avoid the risk and expense of protracted litigation. 3 of 7

4 Section 546 of the Bankruptcy Code, however, provides debtors a relatively small window within which to commence adversary proceedings to recover pre-petition transfers. In most cases, 546 requires that such litigation be brought within two years following the date on which the debtor sought bankruptcy relief. Moreover, because of the exigencies of bankruptcy cases, debtors typically wait until the deadline under 546 is looming before making demand for the return of allegedly preferential payments. Creditors, accordingly, are frequently required to investigate, respond and settle demands for the return of pre-petition payments on very short notice or risk needlessly incurring the expenses associated with fullblown litigation in the bankruptcy court. To facilitate pre-litigation settlements, debtors and creditors often enter agreements to toll or suspend temporarily the deadline to commence avoidance actions under 546. On the other hand, creditors sometimes can gain a strategic advantage by insisting that a debtor comply with the deadlines imposed by 546 and attacking any attempt to recover pre-bankruptcy payments after that deadline as untimely. A recent case decided by the United States Bankruptcy Court for the Northern District of Oklahoma (the Bankruptcy Court or the Court ) provides a particularly good illustration of this tension. In Commercial Financial Services, Inc. v. Temple, 294 B.R. 164 (N.D. Okl. 2003), a defendant in an avoidance action challenged the validity of a tolling agreement it had signed which purported to extend the deadline to bring such actions under 546 and asserted that litigation to recover a substantial pre-bankruptcy transfer was time barred. In support of his challenge to the tolling agreement, the defendant mustered essentially two arguments. First, he claimed that the tolling agreement was not a binding contract because, among other things, the debtor had not communicated its acceptance of the tolling agreement by delivering a signed copy of the agreement to him. Second, and more interestingly, the defendant argued that even if the tolling agreement constituted a valid contract, it was ineffective as a matter of law to waive or extend the two year time bar of 546 because 546 was a jurisdictional statute of repose which may not be modified by an agreement between the parties. The Bankruptcy Court forcefully rejected both of the defendant s arguments. First, the Court ruled that the fact that the debtor had not returned a signed copy of the tolling agreement to the defendant was irrelevant to the issue of whether an effective contract was formed between the parties. Specifically, the Court found that on the particular facts of the case that by signing and returning the agreement the defendant had accepted the debtor s offer rather than making a counter-offer to the debtor and that under applicable state law nothing after acceptance is required to maintain a valid contract. Alternatively, the Court ruled that under applicable state law a writing can be binding if only signed by one party and accepted by the other and found that the debtor had accepted the tolling agreement by deferring its right to sue [the defendant] regarding claims covered in the agreement and announcing in open court that it had entered into a tolling agreement with the defendant. Next, the Bankruptcy Court ruled that 546 was a statute of limitations which was subject to tolling and waiver rather than a statute of repose which established an absolute bar to a plaintiff s ability to bring suit at the time. In reaching this result, the Bankruptcy Court recognized that the courts that addressed the issue of whether 546 was a statute of limitations or a statute of repose are split. The Court found, however, that relevant authority from other courts, as well as the language and legislative history of 546, all lead to the inescapable conclusion that 546 is a statute of limitations. 4 of 7

5 The Bankruptcy Court first noted that statutes of repose in contrast with statutes of limitations were jurisdictional and could not be tolled for any reason. The Court further observed that while the United States Court of Appeals for the Tenth Circuit (the circuit in which the Bankruptcy Court sits) had not directly addressed the issue of whether 546 was a statute of repose, the Tenth Circuit had held that 546 was subject to equitable tolling. The Bankruptcy Court reasoned that this holding was incompatible with a finding that 546 was a statute of repose. In addition, the Bankruptcy Court found further support for its conclusion that 546 was a statute of limitations rather than a statute of repose in Supreme Court dicta which suggests that all of the limitation periods set forth in the Bankruptcy Code are subject to equitable tolling. Finally, the Bankruptcy Court found that the language used in 546 was linguistically similar to typical statute of limitations noted by the [Supreme] Court and that its legislative history also supported the conclusion that the section was a statute of limitations not a statute of repose. Commercial Financial demonstrates that the decision to enter into a tolling agreement should be weighed carefully. By entering into such an agreement, a creditor, by definition, restricts its ability to interpose a defense under 546. The strategic costs associated with an extension of the deadlines to bring avoidance actions, therefore, must be balanced against the likelihood that the parties will be able to negotiate a settlement during the extension. Finally, a defense under 546 can be preserved even if a creditor elects to enter into a tolling agreement by insisting that the debtor specifically identify in the agreement all of the payments and other transfers that are subject to the agreement. Payments not identified in the agreement will be vulnerable to attack as untimely under 546, if the parties are unable to compromise their dispute. NEWS AND NOTES Firm News: Nixon Peabody currently represents two Independent Power Producers (IPPs) in connection with the PG&E National Energy Group s bankruptcy filing in the United States Bankruptcy Court for the District of Maryland (Greenbelt Division). While the representation continues, currently, through the combined efforts of the firm s Bankruptcy, Energy, Tax, Litigation and Structured Finance Groups, Nixon Peabody has already negotiated a successful outcome for at least one of the clients, advantageously navigating the many complex regulatory and jurisdictional issues in just a short period of time. The firm continues its representation of many other clients in this and other currently pending energy cases including Enron and NRG. In August, the plan of reorganization of Crouse Health Hospital and related entities (NDNY) was confirmed. Nixon Peabody represented the largest secured lenders holding approximately $58 million in claims. The plan provided for refinancing of public debt and the restructuring of the largest health care facility in Western New York. Nixon Peabody is serving as special counsel for debtor Global Crossing Ltd. (SDNY) in the negotiation and closing of a $100 million exist financing from GECC and Merrill Lynch. This loan will enable Global to complete its confirmed plan of reorganization and emerge from bankruptcy. 5 of 7

6 Practice Group and Attorney News: Mark Berman Mr. Berman recently began to teach an on-line course on credit law for the National Association of Credit Management. Dan Sklar Mr. Sklar has been asked to teach a course on bankruptcy and re-organization at Franklin Pierce law school starting January Craig Tractenberg Mr. Tractenberg recently won an appeal of a $5 million preference case in the District of Delaware affirming the Delaware bankruptcy court decision. The summary judgment decision eliminated the need to try the merits of the case, which alleged that the debtor had engaged in a fraudulent conveyance of $1.2 billion. The case is Philip Services v. Luntz. William Thomas In early September 2003, the Bankruptcy Court (WDNY) confirmed the plan of liquidation for Niagara Frontier Hockey, L.P. NFHLP was the owner and operator of a NHL team, the Buffalo Sabres Hockey team. Nixon Peabody, with William Thomas as lead counsel, represented NFHLP and nine related debtors. As reported previously, the team was sold to a new group under Section 363 of the Bankruptcy Code. Mr. Thomas is speaking on the topic at the upcoming Turnaround Management Association program entitled The Successful Turnaround of the Buffalo Sabres on October 30 in Buffalo, NY. Peter Tamposi Mr. Tamposi presented at a CLE for the National Business Institute on bankruptcy issues related to foreclosures on September 18, of 7

7 TEAM MEMBERS Dan Sklar (Practice Group Leader) Manchester (603) Mark Berman Boston (617) Renee Bergmann Philadelphia (215) Robert Christmas New York City (212) Amanda Darwin Boston (617) Peter Furness Providence (401) Howard Gorney Boston (617) Victor Milione Boston, (617) James Monroe San Francisco (415) John Snellings Boston (617) Douglas Spelfogel Garden City (516) William Thomas Rochester (585) Lee Harrington Boston (617) Gregory Mascitti Rochester (585) Francis Morrissey Boston (617) Richard Pedone Boston (617) Peter Tamposi Manchester (603) Craig Tractenberg Philadelphia (215) of 7