Bankruptcy law handles LLC interests sparingly
In a relatively short 25 years, the limited liability company (LLC) has become the entity of choice for almost all purposes, with the almost single major exception of publicly traded companies. The more popular the LLC has become, the more likely it is that a debtor starting a bankruptcy case will own an LLC interest as an asset. One problem with this is that the current Bankruptcy Code dates back to many acts of the 1980s, with revisions in 1994 and 2005 — all before LLCs really became popular. The result is that the Bankruptcy Code has no specific provisions to address a debtor’s LLC interests, meaning that debtors, creditors, the trustee, and bankruptcy courts must combine other parts of the bankruptcy law in specific cases to address interests LLC. Inevitably, this has led to substantial confusion, conflicting views, apparently wrong views, and views that have arrived at the correct result through faulty reasoning. Today, we’re looking at one of the latter.
Direct Biologics LLC is a Wyoming entity in which Dr. Kenneth Pettine held about a 2.5% stake. For whatever reason, Pettine filed for Chapter 7 bankruptcy and was appointed a bankruptcy trustee. The trustee initially tried to sell the interest, but the LLC’s operating agreement had a provision preventing it, so the trustee filed a motion for charging order and liquidation (exclusion) of the charged interest, which Pettine opposed, and then the trustee conducted an auction for the interest charged. Pettine then appealed to the U.S. Bankruptcy Court of Appeals for the Tenth Circuit, which then published the opinion in Pettine v. Direct Biologics, LLC (In re Pettine), 2023 WL 7648619 (BAP 10th Cir., Nov. 15, 2023), which I cite below.
Pettine’s appeal was primarily that when he filed for bankruptcy, the trustee immediately had an automatic lien on his LLC interest, so that it was not necessary for the trustee to effectively obtain a second lien on the LLC interest through a charging order. But why should Pettine care?
The reason is that the automatic lien on the debtor’s property in favor of the trustee that is created when the debtor files for bankruptcy will end when the bankruptcy case itself is closed. In contrast, a charging order reservation will survive the bankruptcy case and will therefore be effectively equivalent to what is known as after the report delay. Pettine argued that if the latter happened, then he would essentially not have the “fresh start” that is the primary goal of bankruptcy in the first place, since his interest in the LLC would still be encumbered by the lien of whoever bought the lien at the foreclosure auction. That buyer would have superior rights over Pettine in any distributions made by the LLC, even after Pettine’s discharge from bankruptcy.
The court noted that both the lien created in favor of the trustee at the commencement of a bankruptcy case, known as a § 544 lien, and the charging order lien are both forms of judicial liens (to be distinguished from consensual liens such as the UCC lien). . However, the court disagreed with Pettine that if a trustee obtains a binding charging order, that amounts to a “new” post-petition bar, as Pettine had argued. Because the trustee could avail itself of state law and Wyoming law (applicable to the LLC) permitted a charging order, it was appropriate for the trustee to use the trustee’s powers to avail itself of state remedies through charging order commitment. So, on that basis, Pettine lost.
ANALYSIS
While the court reaches the correct result here, which is that Pettine’s interest in the LLC could be sold, the reasoning the court used is open to serious question. As will be seen, the court uses a “Chicago to Detroit via Miami” type of analysis when there is a simpler and more direct path.
An interest in an LLC is in the nature of a contractual right to payment. When a debtor files for bankruptcy, this contractual right to payment becomes part of the debtor’s bankruptcy estate and thus effectively belongs to the trustee. The trustee can then sell the interest at a trustee’s auction like any other asset of the debtor. This is the direct route “Chicago to Detroit” and it is an essential mystery why this route was not used by the administrator and the courts.
Note that in any case, the most the debtor—whether the trustee, creditor, or auction buyer—can receive is the debtor’s “assignable interest,” meaning the debtor’s right to distributions. This means that if the entire process is followed through to the completion of an auction, what the buyer ends up with is nothing more than an income stream. This income stream is the distributions from the LLC, but does not give the purchaser any other rights or powers, as such purchaser is no more than agent of the debtor’s interest.
Where the path may differ to Miami is when the debtor’s interest is in an LLC executive, which essentially means that a member must do something for the LLC to be entitled to distributions. In this case, § 365 relating to executory contracts comes into play and the trustee’s path to liquidating the interest will become more complicated. But that doesn’t seem to be the case here, and small interests (like the 2.5% rate here) are usually in the nature of non-executive contracts where the debtor’s right to distributions is already vested (usually, they just make their investment in the LLC in the first place).
So why did the trustee and the court go a long way? Well, we really don’t know their thinking beyond what is stated in this opinion, but I would suggest that bankruptcy people (who are not business law people) still have fundamental misunderstandings about the composition of LLCs and see them as more like companies. equity from what it really is, which is a derivative of corporate law which is itself merely a bundle of contractual obligations. When a debtor owns shares in a company, those shares are simply liquidated by the trustee, end of story. But as seen when dealing with an LLC, the rights the debtor holds are a contractual right to payment, much closer to a rights interest as a bankruptcy asset.
So this probably won’t be the last opinion where a bankruptcy court goes from Chicago to Detroit via Miami.
