When someone declares bankruptcy, his financial assets may be claimed by a bankruptcy estate and used to settle his debts. An example of a financial asset that could be transferred to personal debtors is an ownership share in a limited liability company. LLCs are state-approved businesses with a relatively small number of owners, otherwise known as members. The other members of the LLC may not want to have a new owner in the business due to the other member’s bankruptcy. Therefore, the LLC may be structured in a way to address this possibility.
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An LLC’s operating agreement spells out the rules that the members agree to when starting the business. An operating agreement can be oral, but best practices suggest that it should be written down to minimize confusion. The members will normally include the process for admitting new members in the agreement, as well as what to do when a member leaves or if the members want to terminate the business. The agreement should also discuss what to do if a member becomes bankrupt.
A member’s interest in an LLC can be broken into two components: the management interest and the financial interest. The management interest is the right of the member to influence how the business is managed. A bankruptcy court will generally look to the state laws of where the LLC was organized as well as the operating agreement to determine how to proceed. For example, if the operating agreement requires that any transfer of the management interest requires the approval of the non-debtor members, the bankruptcy court will not compel the LLC to transfer the management interest to the bankrupt member's creditors.
The second component of a person’s LLC holding is his financial interest. Most bankruptcy courts are more willing to compel the sale of an economic interest, because it does not influence how the business is run. As a result, the creditors would be able to claim all distributions and dividends from the LLC that would have otherwise gone to the bankrupt member.
Right of First Refusal
The "right of first refusal" is often incorporated into LLC operating agreements. This gives the business the right to purchase a departing member’s interest. In the event of a member's personal bankruptcy, the business would be allowed to purchase the economic interest from the bankruptcy estate. A bankruptcy court, however, might waive this provision regarding the right of first refusal, if it believed that this would prevent the bankrupt member’s creditors from being compensated.