How a Chapter 7 Trustee Administers a Single-Member LLC

On October 12th, I presented to the Chicago Bar Association on how a chapter 7 trustee administers a consumer debtor’s membership interest in a business. This post is the first of two primers borrowing from that presentation, covering trustee administration and issues for consumer bankruptcy attorneys with respect to a single-member LLC. A companion post covers a multi-member LLC, where the trustee’s position and power are ultimately going to be very different.

A consumer chapter 7 bankruptcy is usually about the limited assets owned by an individual. However, when the debtor also owns a company, it complicates the analysis. In nearly every case, the key questions are what the bankruptcy estate owns and what authority the chapter 7 trustee acquires once the case is filed.

What the Estate Actually Owns

Section 541(a)(1) of the Bankruptcy Code brings into the estate all legal or equitable interests of the debtor in property as of the commencement of the case. What those interests are is a question of state law. If the debtor owns an LLC, the company is a separate person, and the debtor simply owns the membership interest in that LLC. Solely the membership interest is therefore property of the debtor’s bankruptcy estate.

This is borne out by the plain language of the Illinois Limited Liability Company Act (the “LLC Act”). Section 30-1(a) of the LLC Act provides that a member “is not a co-owner of, and has no transferable interest in, property of a limited liability company.” Section 30-1(b) provides that the member’s distributional interest is personal property and may be transferred. The membership interest becomes property of the estate. As long as the assets are titled in the name of the LLC, the company’s assets remain the company’s property.

Certain bankruptcy cases from the Northern District of Illinois have applied that rule to consumer debtors. In In re Weiss, 376 B.R. 867, 879 (Bankr. N.D. Ill. 2007), Judge Hollis explained that a “member does not own the underlying assets of the limited liability company and can only transfer his distributional interest.” In Grochocinski v. Campbell (In re Campbell), 475 B.R. 622 (Bankr. N.D. Ill. 2012), a husband and wife each owned fifty percent of a manager-managed Illinois LLC that in turn owned several other companies. The chapter 7 trustee argued that the companies and their assets were effectively estate property. Judge Cassling held that the membership interests were property of the estate, but that the LLC’s assets, including the subsidiary LLCs, were not. Campbell, 475 B.R. at 631-32. I covered a related point in an earlier post on In re Samy, where the cash in a single-member LLC’s account was found to be the company’s asset, not the debtor’s.

In Campbell, the bankruptcy court did not affirmatively state that the trustee could never reach those assets. Rather, the bankruptcy court explicitly noted (in a footnote) that the trustee “has not yet taken the actions necessary under Illinois law to bring that property into this estate.” The actions the trustee had to take were as follows: (a) replace the manager; (b) dissolve and wind up the LLC pursuant to the LLC Act and the operating agreement; and (c) pay the LLC’s creditors first. Id. at 632 & n.7.

Because the company’s assets are not property of the debtor’s bankruptcy estate, the trustee cannot sell them pursuant to section 363 in the debtor’s case. Among other cases, this is clearly illustrated by In re Hopkins, No. DG 10-13592, 2012 WL 423916 (Bankr. W.D. Mich. Feb. 2, 2012). In Hopkins, the debtor was the sole member of a Michigan LLC that owned a parcel of real estate, which the chapter 7 trustee moved to sell pursuant to section 363(b) and (f). The court held that the real estate was not property of the estate and that it had no authority to approve a section 363 sale of it. Hopkins, 2012 WL 423916, at *1. However, because no one objected, the court entered an order confirming that the trustee could act as sole member and, to the extent state law allowed, cause the LLC to sell the property, pay the liens and closing costs, pay the LLC’s creditors from the net proceeds, and treat whatever the LLC then distributed to the trustee as property of the estate. Id. at *1-2.

In re Albright and the Trustee’s Control of a Single-Member LLC

If the trustee wants the value of the company’s assets, the trustee has to administer the membership interest. And in a single-member company, that usually means that the trustee must establish control of the company.

In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003) cleanly illustrates the steps a trustee may take to obtain control of a single-member LLC. In that case, the debtor was the sole member and manager of an LLC that owned real property. The debtor filed chapter 7 and the chapter 7 trustee moved for authority to take the actions necessary to liquidate the property owned by the LLC. Ms. Albright argued that the trustee could not take over management or cause the LLC to sell its real estate. Albright, 291 B.R. at 539-41.

The bankruptcy court disagreed. It held that her membership interest became property of the estate on the petition date, and that because there were no other members, “the entire membership interest passed to the bankruptcy estate, and the Trustee has become a ‘substituted member.’” Id. at 540. Colorado’s statute, like Illinois’s, required the unanimous consent of the “other members” before a transferee could participate in management. In this case, however, there were no other members of the LLC, so no additional consent was necessary. The court held that the trustee, as sole member, controls the LLC and may cause it to sell its property and distribute the net proceeds to the estate, or, alternatively, may distribute the LLC’s property to the estate and liquidate it himself. Id. at 542.

Importantly, in this case, the real estate did not become property of the debtor’s estate. The trustee simply gained control of the LLC and was given authority to cause the LLC to sell its own property. The net proceeds of that sale would then come out to the sole member, which was now the estate. In other words, the fact that the real estate is titled in the LLC’s name does not prevent the trustee from realizing its value through control of the LLC.

The Difference Between Member-Managed and Manager-Managed Entities

Control of an entity is not automatic in every single-member case. It depends on how the company is managed (which the operating agreement makes clear). In the event the operating agreement is silent, pursuant to section 15-1(a) of the LLC Act, an Illinois LLC is member-managed. In a member-managed company, the member’s management rights go with the membership interest, and Campbell confirms that those rights are a property interest that transfers to the estate pursuant to section 541. Campbell, 475 B.R. at 631 n.6.

A manager-managed company, on the other hand, is treated differently. Campbell held that the ability to serve as manager of a manager-managed LLC is not a property interest that transfers to the estate, so the debtor who was the manager “retains that role even after filing this bankruptcy petition,” unless and until the trustee, acting as sole member, removes and replaces him. Id. at 631. Pursuant to section 15-1(c)(3) of the LLC Act, a manager is removed or replaced by a vote, approval, or consent of a majority of the members. In a single-member company the trustee is going to be the only member with that authority. The trustee can therefore execute a short written consent, removing the debtor as manager, and appointing the trustee or someone the trustee designates. However, until the trustee actually takes that step, the debtor is still the manager and is still in charge of the entity.

Administering a Single-Member LLC in Chapter 7

When a single-member LLC owns something of value, the following is an illustration of the steps a chapter 7 trustee may take in order to determine whether to administer the property:

• The trustee identifies the interest. The membership interest should be scheduled on the debtor’s Schedule A/B. Note, as discussed below, that it is far better to disclose it than to have the trustee find it on a tax return, a K-1, or a Secretary of State search.
• The trustee demands certain documents to determine the situation with the entity. Some common requests would be: (a) the articles of organization; (b) the operating agreement; (c) titles for any titled assets; (d) bank statements for both the debtor and the company; (e) the last tax return; (f) a list of company creditors; and (g) any mortgage or UCC filing against company assets.
• The trustee then determines whether the interest is worth administering. A single-member LLC that owns assets with equity is often worth administering. A single-member LLC that owns assets without equity, on the other hand, may be abandoned pursuant to section 554.
• To the extent the interest is worth administering, the trustee establishes control. In a member-managed company, the trustee will take the position that the trustee became a substitute member and already holds the management rights. In a manager-managed company, the trustee (as the sole member), removes the debtor as manager, via written consent. Some trustees may also file a motion in the underlying bankruptcy case asking the bankruptcy court to confirm that the trustee controls the LLC and may cause it to sell its assets, as the trustees did in Albright and Hopkins. The relief requested is really a comfort order, so that a title company and a buyer will treat the trustee as the person who can bind the company. Given this, some judges will enter such an order, while others may tell the trustee that such relief is unnecessary and to proceed pursuant to state law.
• The company (acting through the trustee) sells the company’s asset. Company liens remain until they are paid at closing, and the company’s other creditors have to be addressed first. The net proceeds are then distributed to the debtor’s bankruptcy estate.
• Any funds left after paying creditors are distributed to the estate. Section 541(a)(6) of the Bankruptcy Code brings into the estate the “proceeds, product, offspring, rents, or profits of or from property of the estate.” A distribution on the membership interest is proceeds of the interest and the trustee then administers it like any other estate cash.

Transferring the Interest Pre/Post-Petition

Some debtors may believe that it is cleaner to give up the interest or add a second member prior to, or after, filing bankruptcy. After the petition date, any interest in a company is estate property and a transfer of that interest is avoidable pursuant to section 549 of the Bankruptcy Code. Adding a new member after the case is filed does not turn the case into a multi-member case, given that the transfer of the interest can be avoided.

Transferring an interest shortly before the petition is a fraudulent transfer issue, pursuant to section 548 or section 544(b) of the Bankruptcy Code. Indeed, Albright itself warned that a “peppercorn” co-member added to hinder, delay, or defraud creditors is dealt with through “bankruptcy avoidance provisions and fraudulent transfer law.” Albright, 291 B.R. at 541 n.9.

Practical Considerations for Consumer Bankruptcy Attorneys

For consumer bankruptcy attorneys, a number of questions should be answered before a chapter 7 bankruptcy case is ever filed because a potential debtor who owns a single-member LLC is not the typical consumer debtor. The following are the practical points to cover at intake and in preparing the schedules:

• Determine the Nature of the Business. When discussing a potential chapter 7 case, ask the debtor whether he owns an LLC or other entity. If the answer is yes, determine whether anyone else is a member, whose name is on the title and the bank account, whether there is a signed operating agreement, and whether the company is member-managed or manager-managed.
• Ensure the Schedules are Correct. Make certain that the relevant documents (discussed above) are consistent with the schedules. Ensure that the membership interest is scheduled. Failure to properly schedule assets could result in a nondischargeability complaint and/or increased scrutiny from the chapter 7 trustee.
• Determine Potential Trustee Interest in the Company Assets. While the trustee cannot treat the company’s assets as the debtor’s assets, the trustee in a single-member company can take control of the membership interest, cause the company to sell its assets, pay the company’s creditors, and bring the net proceeds into the estate.
• Do Not Transfer the Membership Interests Pre-Bankruptcy. In the event a debtor transfers interests prior to the bankruptcy filing, the trustee will ask when the second member came in, what that person paid, and whether that person ever received a distribution. To the extent those answers are unsatisfactory, the trustee may seek avoidance of those transfers, which can have serious consequences for a chapter 7 debtor.

If you represent a consumer debtor who owns a business or if you are a trustee deciding whether a membership interest is worth administering, the attorneys at FactorLaw can help you work through the operating agreement, the LLC Act, and the steps that actually bring value into the estate (or whether bankruptcy is in the best interest of the debtor, at all).