Limited Liability Company Members and Bankruptcy

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The intersection of the rights of limited liability company members and bankruptcy laws was recently addressed by the Washington Supreme Court, when the Court addressed the status of an LLC member’s membership interest in a voluntary bankruptcy case.

A couple (the Ostensons) and another party (Holzman) agreed to form an LLC to operate in the Washington fruit industry. Holzman was the majority owner. When the LLC became financially distressed and defaulted on an operating line of credit, Holzman fired the Ostensons and took control of the LLC. He caused the LLC to issue a promissory note to another entity he owned (the Holzman entity), and then transferred the LLC’s assets to the Holzman entity as payment of the promissory note. Ostenson then filed a voluntary Chapter 11 bankruptcy case.

One of the LLC’s lenders did not appreciate the transfer of the LLC’s assets to the Holzman entity, and filed a fraudulent conveyance lawsuit against the Holzman entity, the Ostensons and the LLC. Ostenson then filed various claims against the LLC and as against the Holzman entity and other parties. The claims filed by the Ostensons against the LLC were derivative claims, meaning that they were filed to enforce a right of the LLC which the LLC itself was not enforcing.

Ultimately, Holzman and his entities and the lender settled their dispute, and the only remaining claims to go to trial were the derivative action claims filed by Ostenson (which were filed after they commenced their voluntary Chapter 11 bankruptcy case).

Holzman argued that Ostensons had no right to maintain or bring the claims because Ostenson’s membership interest in the LLC was automatically terminated  by the filing of the bankruptcy case under Washington  law, which states that an LLC member’s membership interest is automatically terminated (an “event of dissociation”) by the filing of a voluntary bankruptcy petition under RCW 25.15.130(d).

The Ostensons argued that Federal bankruptcy law preempts state law, and that the Washington LLC Act provision which terminates an LLC member’s interest upon the filing of a voluntary bankruptcy petition is  unenforceable (Ostenson claims that it is an “ipso facto” clause, which are generally unenforceable).

The Decision and Outcome

In its decision, the Washington Supreme Court discussed the point that a bankruptcy filing automatically creates a bankruptcy estate into which the debtors’ property interest “devolves.” Whether a property interest exists or is created is defined by state law; whether the interest (if it is created) is counted as “property of the estate” is determined under Federal law. The Court went on to hold that the bankruptcy estate takes the LLC membership interest “burdened by whatever state law requires.”

So, if an LLC member files a bankruptcy case, and assuming that state law says that the membership is terminated automatically upon the filing of the bankruptcy, then the bankruptcy estate takes the terminated membership interest. In Washington state, a terminated membership interest is an economic interest only and has no voting or other management rights (this is generally the same outcome if an LLC member assigns an LLC interest or sells it without getting the permission of the other LLC members).

This outcome was not the result desired by the Ostensons. Since their membership interest in the LLC was terminated by operation of Washington law, they had no right to participate in management of the LLC, and therefore could not maintain the lawsuit against Holzman as a derivative action.

Northwest Wholesale, Inc. v. Pac. Organic Fruit, LLC, No. 90891-5, 357 P.3d 650 (2015).