Members Only: Can a Trustee Govern an LLC When Its Member Files for Bankruptcy?

Abstract

Limited-liability entities allow owners to limit their personal risk similar to shareholders of a corporation while enjoying the ability to operate the business more in the manner traditionally used for a partnership. These attributes have made these business forms increasingly popular business over the past few decades because they offer the best of partnership world—control and pass-through taxation—while also offering the best of corporate world—limited liability to all of its owners. But if financial problems arise for these businesses and their owners, bankruptcy may be the final option to remedy financial difficulties. The current bankruptcy code, adopted at the same time that LLCs first came into existence, has faced various issues involving these new business entities. This Article considers the ability of a bankruptcy trustee to govern an LLC when one of the members of the LLC files for bankruptcy protection. When a member of an LLC files a bankruptcy case, the member’s interests in the LLC transfer to the estate. These interests include the right for the member to be paid by the LLC, known as economic interests, as well as governance interests. Governance interests include the right to manage the business and non-management interests such as the right to vote or seek dissolution of the entity. The transfer of economic interests into the estate provides no risk to the non-debtor members of the LLC, and the bankruptcy code and state laws together make the debtor’s economic interest in the LLC available to pay creditors. But the transfer of governance rights to the trustee violates state law and threatens the fundamental “pick your partner” principle that governs LLCs. This Article concludes that bankruptcy cases allowing the trustee to take over a member’s governance rights, particularly in the context of a multi-member LLC, ignore fundamental principles of state business law and violate one of the essential aspects of the LLC—the ability for its members to choose their own managers