An operating agreement (“Operating Agreement”) is the formal agreement between members (individually, a “Member” and collectively, the “Members”) of a limited liability company (the “LLC”) governing the business of the LLC, as well as the financial and managerial rights and obligations of the Members of the LLC. Members of the LLC can choose to appoint an individual as the “Manager” of the LLC in the Operating Agreement, with broad authority to take action on behalf of the LLC without the need to obtain the consent of each Member. Alternately, the Members can choose to appoint an individual as the “Manager” of the LLC with the authority to take most actions on behalf of the LLC, but require that some actions be approved by Members holding a certain percentage of the Interests[1] in the LLC. There is no limit to the number of variations to the management provisions of a LLC Operating Agreement.

When making a loan to a LLC, lender’s counsel should carefully examine the provisions of the Operating Agreement relating to the management rights of the Members of the LLC, to determine what organizational action needs to be taken to properly authorize the LLC’s entry into the loan documents. But, what happens when the original loan needs to be modified and one of the Members that needs to consent to the modification of the loan documents has since filed for bankruptcy? Can the loan be made between the LLC borrower and the Lender be modified without the consent of the bankrupt member?

Upon first impression a Lender may believe that common provisions in the LLC Operating Agreement and the LLC Act divest bankrupt LLC members of their voting rights in the LLC. This belief would be reasonable, but it is wrong.

By way of background, typical LLC Operating Agreements provide that “immediately upon the occurrence of an Involuntary Withdrawal (which typically includes the filing of bankruptcy by such member)[2], that Member shall thereupon become an Interest Holder[3]but shall not become a Member, and shall have all the rights of an Interest Holder.” The effect of such a provision is the divestiture of voting rights of the Member upon the bankruptcy, but retention of the “economic” rights (i.e the rights to profits etc.). In fact, and completely independent of the Operating Agreement, Section 4A-606(3)(ii) of the Maryland Limited Liability Company Act (the “Act”) also provides that: “A person ceases to be a member of a limited liability company upon the occurrence of any of the following events …. (3) Unless otherwise provided in the operating agreement or with the consent of all other members, the person: …. (ii) Files a voluntary petition in bankruptcy ….”

Unfortunately, both the LLC Operating Agreement and the LLC Act are ineffective in the face of federal bankruptcy law. In the case entitled “In re Lee J. Jundanian” 2012 WL 1098544, the United States Bankruptcy Court for the District of Maryland cited to Section 541(c)(i) of the United States Bankruptcy Code which states that “[A]n interest of the debtor in property becomes property of the estate… notwithstanding any provision in an agreement, transfer instrument, or applicable non-bankruptcy law” in rejecting the movant’s argument that the provisions of the LLC Operating Agreement and the LLC Act divested the bankrupt member and the bankruptcy estate from bankrupt member’s membership interests. What this means for Lenders and their counsel is that the bankrupt LLC member’s approval was required to modify any loan or other agreement pre-bankruptcy; their rights do not just dissolve as the LLC Operating Agreement and LLC Act would have you believe, but instead pass to the bankruptcy estate.

[1] Interests being generally defined as a person’s share of profits and losses, and share of distributions from the LLC, and with respect only to a Member, a person’s right to vote on any matters for which Members may vote.

[2] The definition of an Involuntary Withdrawal being defined as including (but not being limited to) a Member filing a petition for bankruptcy.

[3] An Interest Holder being defined as any person holds an Interest, whether as a Member or as an unadmitted assignee of a Member.