Daily Development for Friday, April 25, 2003
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
dirt@umkc.edu

Here is another characteristically thoughtful, well researched, and
unbelievably lengthy item from the keyboard of Jack Murray at
First American Title Insurance in Chicago.  Editing has been
technical only.  The editor is speechless, but he recommends that
those with practice concerns involving LLC's, especially in
"bankruptcy remote" settings such as in securitizations, should
study every word.

BANKRUPTCY; PROPERTY OF THE ESTATE; SINGLE
MEMBER LLC'S:  Efficacy of a single-member LLC as an
asset-protection vehicle thrown into doubt.

In re Ashley Albright, 2003 Bankr. LEXIS 291 (Bankr. D. Colo. April
4, 2003),

Debtor, who filed a Chapter 13 bankruptcy petition that was later
converted to a Chapter 7 liquidation, was the sole member and manager
of a Colorado LLC at the time of the filing. The LLC was not a debtor in
bankruptcy. The Chapter 7 trustee contended that because Debtor was the
sole member and manager at the time Debtor filed bankruptcy, the trustee
now controlled the LLC and could therefore sell the real property owned
by the LLC and distribute the net sales proceeds to the bankruptcy estate.

Debtor argued that the trustee acted only for Debtor's creditors and at
most was entitled to a statutory charging order (against distributions
made on account of Debtor's LLC membership interest) and could not
assume management of the LLC or sell its property.

The court, however, disagreed.  It  referred to the Colorado LLC statute,
under which Debtor's membership interest constituted the personal
property of the member. According to the court, "[b]ecause there are no
other members in the LLC, the entire membership interest passed to the
bankruptcy estate, and the trustee became a 'substituted member.'" The
court also stated that, "upon the Debtor's bankruptcy filing, the Trustee
now controls, directly or indirectly, all governance of that entity,
including decisions regarding liquidation of the entity's assets." The court
reasoned that because there were no other members in the LLC, no
written unanimous approval of the transfer was necessary, as would be
the case under Colorado law if there were other members - no matter
how small such other membership interests may be.

Colorado's LLC statute, similar to those in other states, provides that if
the unanimous consent of all members in a multi-member LLC is not
obtained, the bankruptcy estate is only entitled to receive the bankrupt
member's share of the profits or other compensation that the bankrupt
member was otherwise entitled to, and would not be entitled to any role
in the voting or governance of the LLC. However, in a footnote the court
stated that this statutory limitation "does not create an asset shelter for
clever debtors.  To the extent a debtor intends to hinder, delay or defraud
creditors through a multi-member LLC with 'peppercorn' co-members,
bankruptcy avoidance provisions and fraudulent transfer law would
provide creditors or a bankruptcy trustee with recourse.".

The court rejected Debtor's assertion that the trustee should be entitled
only to a charging order, finding that a charging order existed only to
protect other members of an LLC, and in a single-member LLC there
were no non-debtor members to protect. The court ruled that the trustee,
as the sole member of the LLC, therefore controlled the LLC and could
cause the LLC to sell its property and distribute the net proceeds to the
bankruptcy estate, or alternatively the trustee could elect to distribute the
LLC's property to the bankruptcy estate and then liquidate the property
himself. However, the court did permit Debtor to make a claim for her
post-petition mortgage payments to preserve the real property of the
LLC, which was now an asset of the bankruptcy estate.

Reporter's Comment 1:   Under most state LLC statutes if a member files
a bankruptcy case the LLC automatically dissolves (unless otherwise
specified in the operating agreement). Is this provision of a state LLC
statute overridden by the Bankruptcy Code because it constitutes an
*ipso facto* clause (i.e., a clause that modifies or eliminates a party's
contractual rights solely because of a bankruptcy filing) which is
unenforceable under sections 541(c)(1), 363(l) and 365(e) of the
Bankruptcy Code?

The answer may depend on whether the articles of organization and
operating agreement are regarded as executory contracts (i.e., contracts
on which performance remains due to some extent on both sides). The
question then becomes whether these documents are "organic" governing
documents (as opposed to executory contracts) and whether a bankruptcy
court, even if it held the documents to be executory, would enforce the
documents with the sole exception of the bankruptcy-remote provisions
if the agreements were rejected, or permit such rejection to cause a
dissolution of the LLC without providing at least a "winding down"
period.

Reporter's Comment 2:   Because LLCs are still relatively new state-law
creations, the treatment of these entities in bankruptcy is uncertain, i.e.,
will they be treated as partnerships or corporations for bankruptcy
purposes?  See In re ICLNDS Notes Acquisition, LLC, 259 B.R. 289, 292
(Bankr. N.D. Ohio 2001) ("an LLC is neither a corporation or a
partnership, as those terms are commonly understood. Instead, an LLC is
a hybrid"). This uncertainty is especially troublesome with respect to
single-member LLCs.  This is because if an LLC is treated as a
partnership, it could dissolve upon the bankruptcy of its sole member and
its assets distributed to creditors and the bankrupt member (or, as in the
Albright case, to the trustee of the bankruptcy estate). If, on the other
hand, the LLC were treated as a corporation, it would not dissolve upon
the bankruptcy of the last remaining member, although the member's
ownership interest could be transferred.

Some commentators believe that, at least under the Delaware Limited
Liability Company Act ("DLLC Act"), an LLC should be treated as a
corporation because the LLC operating agreement is similar to a
certificate of incorporation and a member's interest is analogous to a
share of stock in a corporation. See Larry E. Ribstein and Robert R.
Keatings, Limited Liability Companies,  14.04, at 14-18 (2000)
("[F]rom a policy standpoint, LLCs probably should be considered
corporations for bankruptcy purposes because the special bankruptcy
provisions that apply to partnerships primarily relate to the general
partner's duty to contribute to payment of the firm's debts"); Carter G.
Bishop and Daniel S. Kleinberger, Limited Liability Companies Tax and
Business Law, 1.04 (2)(a) (1999).

Reporter's Comment 3:   Since 1998, single-member LLCs have become
very popular in securitized and structured-financing transactions because
of their tax advantages, flexibility and low transaction costs. However,
there is a question as to whether a single-member LLC will continue to
exist upon the sole member's bankruptcy, death, or dissolution.  There is
very little legal precedent or case law on this issue.  The governing law
must be consulted to see if it allows for the continued existence of the
LLC after the sole member's bankruptcy or dissolution.  For example, the
DLLC Act (under which many LLCs are formed because of the favorable
statutory framework) specifically provides for the LLC's continued
existence under such circumstances, unless otherwise provided in the
operating agreement. See Del. Code Ann. tit. 6,
18-801 (a)(4). The DLLC Act also provides that by default an LLC's
existence is perpetual. Del. Code Ann. tit. 6,  18-801 (a) (1). A
single-member LLC, whose only member is the entity or individual in
question, requires the creation of only one entity, the LLC itself.  See
Larry E. Ribstein and Robert R. Keating, Ribstein and Keating on
Limited Liability Companies, Ch.
4, p.3 (1996) (Fall 2001 Update).

Reporter's Comment 4:   Bankruptcy courts generally look to state law to
determine whether dissolution occurs upon the bankruptcy of the sole
member of a single-member LLC.  Under the DLLC Act, for example, an
LLC whose member is in bankruptcy would be treated as if it were a
corporation with a bankrupt shareholder and the bankruptcy would not
cause a dissolution.  If a Delaware LLC agreement is properly drafted,
under Delaware law even the bankruptcy of the last remaining member
will not, by itself, cause the dissolution of the LLC.

Furthermore, under the DLLC Act, it is permissible to admit "springing
members," i.e., a person may be admitted as a member (including as the
sole member) without acquiring an interest in the LLC or being required
to make a capital contribution. See Del. Code Ann. tit. 6,  18-801(a)(4)
and (b); James G. Leyden Jr., A Key State's Approach to LLCs:
Delaware Can Be Different, 9-MAY Bus. L. Today 51, 63 (2000).

Reporter's Comment 5:    The single-member LLC operating agreement
should specifically provide for the continued existence of the LLC upon
the sole member's dissolution or the termination of its membership in the
LLC.  The operating agreement also should condition the sole member's
right to withdraw on the existence of a succeeding member (or
"springing" member) who would be capable of continuing the operations
and existence of the LLC..   Typical "bankruptcy remote" provisions,
which are promulgated by rating agencies and appear in almost all LLC
formative documents involving securitized loan transactions, also would
be applicable with respect to single-member LLCs. Legal opinions as to
the bankruptcy remoteness of the borrowing entity (and perhaps its
principals) are also usually also required by the rating agencies, such as
Moody's, Fitch, and Standard & Poor's, in connection with securitized
financing transactions to provide support for a high rating. This is
especially so in connection with a single-member LLC, where the
bankruptcy treatment of such a vehicle is less clear. The enforceability of
choice-of-law provisions in LLC documents is also extremely important,
because the ability of a single-member LLC to continue in existence after
the departure of the sole member is often dependent on state law that
enables the single-member LLC to continue in existence.

Reporter's Comment 6:    The DLLC Act also specifically provides for
the exercise of a deceased or terminated member's rights by a personal
representative. Del. Code Ann. tit. 6,  18-705.  The DLLC Act also
provides for termination of an LLC without members, but contains a
mechanism to prevent the winding up the LLC.

The DLLC Act permits the admission of a personal representative of the
departed member within 90 days after such departure, if the
representative agrees in writing to be admitted or such representative is
admitted pursuant to a provision in the LLC agreement providing for
such admission on the departure of a member. See Del. Code Ann. tit. 6,
 18-801(a)(4).

Reporter's Comment 7:   It has been suggested that the single-member
LLC operating agreement provide (where permitted) that a board of
managers, containing at least two "independent" members, would govern
certain management and operating decisions. The operating agreement
would provide that no bankruptcy filing or related action could occur
without the unanimous consent of all the board members. See Alexander
Dill, Yaron Ernst, Michael Kanef, and Adam Toft, Handle With Care:
Single Member LLCs in Structured Transactions, Special Report,
Moody's Investor Services, March 19, 1999. However, if the outside
managers are not truly independent and do not perform their fiduciary
duty to the entity (and to all creditors, including unsecured creditors), as
opposed to specific third-party creditors, the goal of
bankruptcy-remoteness may not be achieved.

The inclusion, however, of such a "bankruptcy remote provision" in an
LLC operating agreement, especially one that requires approval of certain
entity actions by an independent director who is in actuality under the
influence of a major secured lender, may later be determined by a
bankruptcy court to run afoul of the Code's prohibition of provisions
preventing an entity from commencing a bankruptcy reorganization.

Also, several courts have held that as an entity approaches insolvency,
i.e., becomes unable to pay its debts as they become due in the ordinary
course of business, the directors owe a fiduciary duty to all the creditors
of the company. See, e.g., In In re Kingston Square Associates, 214 B.R.
713, 735 (Bankr. S.D.N.Y. 1997). In this case, the debtor was unable to
obtain its board of directors' permission to file a voluntary bankruptcy
proceeding because of the refusal of the "independent director" to
authorize such a filing. The debtor then orchestrated an involuntary filing
by certain unsecured creditors (with the help of the debtor's limited
partners). The bankruptcy court found that such actions were not taken in
bad faith and that the debtor reasonably believed that the best course of
action for the entity was to file bankruptcy. The court further held that
such actions were necessary because the "independent director" had
abdicated his fiduciary duty to the debtors, creditors and limited partners
in favor of the interests of the mortgage lender. The court therefore
refused to grant the secured creditor's motion to dismiss the involuntary
filing. The court also appointed a Chapter 11 trustee, and held that the
debtor's board of directors had violated their fiduciary duties owed to the
debtor, its limited partners and its unsecured creditors and interest
holders, in favor of the interests of the mortgage lender. The court
declined, however, to specifically nullify the debtor corporation's bylaw
provision containing the bankruptcy-proof provisions as against public
policy.

Reporter's Comment 8:   Another proposed method of enhancing the
bankruptcy-remoteness of a single-member LLC is to structure the entity
so that the sole member is itself a single-purpose bankruptcy-remote
entity. Unlike an individual, who can (and eventually will) die, the sole
member of a single-member LLC that is itself structured as a single-asset
bankruptcy-remote entity will have a perpetual existence. However,
borrowers may resist the imposition of such a requirement because they
lose some of the flexibility and cost-saving advantages, including direct
personal ownership, of single-member LLCs.

The Reporter for this item is Jack Murray of First American Title
Insurance Company.

Readers are encouraged to respond to or criticize this posting.

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