Bankruptcy Treatment Of LLC Membership Interests

A debtor’s LLC membership interest is treated differently in state court collection proceedings than it is in bankruptcy. In state court collections a judgment creditor’s remedy to execute a judgment against a multi-member LLC is limited to a charging lien. The lien gives the creditor a right to receive any distributions of money or property from the LLC to the debtor member.

Bankruptcy trustees have greater rights against the bankruptcy debtor's LLC membership interest. The general rule is that a trustee can sell the debtor’s right to distributions. The trustee is not limited to a charging lien and does not have to wait until the LLC actually makes a distribution. In addition, the trustee may also be able to sell the debtor’s voting and management rights and powers in the LLC depending upon the LLC’s operating agreement.

If the operating agreement between the LLC and members is an “executory contract” then the trustee cannot sell management rights; he can only reject or assume the debtor member’s contract position. If the trustee assume the contract he may be responsible to perform the debtor’s contractual duties including making additional capital contributions. If the LLC operating agreement is not an executory contract- the debtor has rights to income but no duties or performance requirements- the trustee can sell the debtor’s entire LLC interest.

It is important that people forming a new LLC draft the operating agreement to include provisions that make the LLC agreement an executory contract to better protect members who may have to file bankruptcy. Some time ago an article appeared in the Florida Bar Journal on this subject. The article set forth specific LLC terms and conditions that protect members in a bankruptcy proceeding.