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What Happens When … an LLC Member Files for Bankruptcy?

IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities. Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses. The following blog has been provided by Robert Salier of the Pacific Northwest Law Group (www.pnwlg.com).

What Happens When … an LLC Member Files for Bankruptcy?

Under the Washington Limited Liability Companies Act and pursuant to many LLC operating agreements, members may lose membership rights under certain circumstances. This loss of rights is called (in Washington) dissociation. One dissociation event is filing for bankruptcy. So what happens if an LLC member files for bankruptcy? By Washington statute (RCW 25.15.130), unless otherwise provided in the limited liability company agreement, that member is dissociated and no longer has the ability to control the LLC. However, some have argued that the United States Bankruptcy Code preempts Washington law and requires that membership and management rights be retained after filing by the filing member.

▶A recent Washington State case from the Washington Supreme Court provides Washington LLCs with some guidance regarding how such cases will be handled in the future.

Unless and until a federal court rules that the bankruptcy code preempts Washington State Limited Liability Companies Act in regard to dissociation upon bankruptcy; members can rest assured they will not end up doing business with whoever bids the highest on the lost membership of the bankrupt member.

In the case, Northwest Wholesale, Inc. v. Pac Organic Fruit, one member of Pac Organic Fruit, a Washington State LLC, Greg Holzman, argued that the other members, married couple Shirley and Harold Ostenson, had been dissociated due to the Ostensons filing for bankruptcy.

The facts of this case provide that Holzman and the Ostensons formed an LLC. They were both members (though Holzman’s membership was held by another LLC in an effort to obtain further limitation on liability) of the LLC. Under the LLC’s operating agreement, a member was dissociated on the event of any occurrence set forth in the Washington Limited Liability Companies Act (the “Act”). Within the Act, a member is dissociated upon filing for bankruptcy (RCW 25.12.130). After a series of unfortunate business dealings, the Ostensons filed for bankruptcy. Holzman claimed (among other things) that the Ostensons lacked standing to bring a claim because they had been dissociated from the LLC (due to filing for bankruptcy) and could not bring a derivative action.

According to the Act, a disassociated member retains its ownership interest, but has no rights to manage the LLC. Under 11 U.S.C. Section 541 of the Bankruptcy Code of the United States, the filing of a bankruptcy case creates a bankruptcy estate comprising all equitable interests of the debtor (in this case the Ostensons) in property, including interest of an LLC. However, case law has provided that where an interest of the debtor is property of the estate, a debtor’s property rights are defined by state law. Washington law defines what property rights the Ostensons held. It follows that while the Ostensons retained their property (i.e. membership interest in company), it was only retained to the extent that such property is defined by Washington law. Because Washington law provides that a member of an LLC attains the status of an assignee upon the filing a voluntary petition in bankruptcy, and an assignee does not have the managerial rights of a member, the Ostensons lacked standing to file a derivative action.

The most the dissociated member will add to the bankruptcy estate is his or her interest as an assignee of the LLC.
Washington LLCs and their members can feel confident that the operating agreement and the Washington State Limited Liability Companies Act will determine when and whether a member is disassociated due to bankruptcy and what the terms of that disassociation will be.
If you have questions related to any of the legal implications affiliated with bankruptcy for a LLC member Bob Sailer would welcome the opportunity to discuss the situation with you. Mr. Sailer can be reached at (425) 867-0512 or Bob@pnwlg.com .

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