PROTECTING YOUR LLC OR LIMITED PARTNERSHIP- BANKRUPTCY- PART 3May 25, 2020 | Category: Asset Protection, Corporate and Taxation, Estate Planning and Probate, News
This is Part 3 of a series on Bankruptcy. This article will discuss the necessity of making the Limited Partnership Agreement or the LLC Operating Agreement an executory contract.
Feel free to review Part 1 and Part 2.
Many of our clients have set up LLCs and to a lesser extent, limited partnerships, in order to safeguard their non-exempt assets. Assets that are not exempt under Florida law such as stocks, bonds, money market funds and real estate other than the homestead are placed in these entities. For convenience, we will assume we are dealing with an LLC, although the rules are the same for limited partnerships.
If the LLC is owned by more than one person and there are no fraudulent conveyance issues (e.g., LLC formed and/or funded after the debt was incurred, etc.), a creditor of an LLC member’s sole remedy is a charging order. This means that the creditor can only intercept distributions from the LLC that otherwise would go to the debtor-member.
If properly done, the creditor’s right is illusory. The creditor cannot vote in LLC maters, can’t force a distribution, and has no right to see the books and records of the LLC. What often happens in this stand-off is that the creditor settles for pennies on the dollar.
Here we discuss the executory contract. An executory contract is one in which a party’s failure to perform its obligation is substantial enough so that the other party is legally excused from its performance. Many sales contracts are executory contracts. If the seller does not perform by delivering the goods, the buyer is excused from his performance-to pay for the goods.
The LLC Operating Agreement is a contract. In order to make it an executory contract, the members need to have material obligations such that if one member fails to do what is required under the Operating Agreement, the other members are legally excused from performing. Such obligations can include funding their allocable share of capital calls, guaranteeing LLC obligations, and performing significant services.
If these requirements result in the Operating Agreement being treated as an executory contract, the Trustee in Bankruptcy under Chapter 7 (Liquidation) needs to decide if he or she wants to assume or reject the contract. If the Trustee assumes the contact, he or she becomes a member with the same obligations as the debtor-member. While the Trustee would be the hook for a large financial obligation, the debtor-member would lose his or her interest. If the Trustee rejects the contract, the debtor-member keeps his interest in the LLC. Most likely the LLC interest will be rejected by the Trustee because it involves significant obligations.
As a precaution against the Trustee actually assuming the LLC membership interest, we typically make most the LLC interest owned by a married couple as tenants by the entirety. This means that unless both spouses are jointly liable to the same creditor, such membership interest does not become part of the bankruptcy estate and is not at risk.
If the Operating Agreement is not an executory contact, the Trustee takes the membership interest without the obligations under the Operating Agreement. The Trustee might then try to force a distribution from the LLC on the basis that the LLC has funds in excess of the needs of the business, and it would be a breach of fiduciary duty not to make a distribution.
This is what you need to do. Ask your attorney to review your LLC Operating Agreement (or Limited Partnership Agreement) to verify that it constitutes an executory contact. Otherwise, you may lose your interest in the LLC or Limited Partnership Agreement in bankruptcy.
Stay safe. Stay well.