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How Does a Bankruptcy Impact an LLC?

By October 11, 2016 No Comments

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Starting a business is a decision bred in hope, optimism and belief in an idea. When individuals get together to start a business, it is because they have an idea that they believe will be profitable, will engage their target market, and will maybe even make the world a better place. Business requires a certain degree of pragmatism, and frequently, the desire to limit personal liability for a new business venture will lead to the formation of a limited liability company (LLC). When multiple members join together to form an LLC, it is because they believe in the purpose for which the LLC was formed and that they can work in tandem to turn that purpose into a profit.

But, what happens if things don’t work out for the LLC? Or, what if the LLC is doing swell, but one of the LLC’s members files for bankruptcy? Under Washington law, unless the LLC members agree otherwise, a member of an LLC who files for bankruptcy is automatically dissociated as a member of the LLC. RCW 25.15.131(1)(f).  Meaning, the bankrupt member loses the right to participate as a member in the LLC’s management and conduct business on behalf of the LLC, although that member retains the economic value of the interest in the LLC, as well as any responsibility for existing liabilities of the LLC. RCW 25.15.131(3).

This provision has teeth. Last year, the Washington Supreme Court ruled that federal bankruptcy law does not preempt the member dissociation provision in the Washington LLC Act in Northwest Wholesale, Inc. v. Pacific Organic Fruit LLC. This case involved a LLC member who filed bankruptcy, and thus became dissociated from the LLC. The dissociated member later attempted to file a lawsuit on behalf of that LLC, arguing that federal bankruptcy law preempted the dissociation provisions of the Washington LLC Act. This argument is based on the Supremacy Clause of the U.S. Constitution (Article VI, Clause 2), which provides that federal laws shall preempt state law. So why doesn’t federal bankruptcy preempt the Washington LLC Act?

The trial court, the Court of Appeals, and the Washington Supreme Court all rejected this argument that federal bankruptcy law preempted the dissociation provision of the Washington LLC Act, preventing the dissociated LLC member from filing a lawsuit on the LLC’s behalf. The United States Supreme Court refused to grant certiorari, allowing the state Supreme Court decision to stand. The Supreme Court issued its denial of the petition in this matter (found under Ostenson v. Holzman) on March 21, 2016 —  a little over a month after Justice Scalia passed away. (Was Justice Scalia’s absence relevant to the Supreme Court’s decision to let the state court ruling stand? Possibly. For an analysis of the dramatic and swift manner in which Justice Scalia’s departure altered the Court, see this article by Jeffrey Toobin in The New Yorker.)

In Northwest Wholesale, the Washington Supreme Court reasoned that state law defines the scope of a bankruptcy debtor’s interests, and then it is the federal bankruptcy code which brings those interests defined by state law into the scope of the bankruptcy. Thus, where state law denies certain rights to bankruptcy debtors, federal law will not create an alternate path for restoring those rights. In other words, under Washington law, the bankrupt LLC member lost his rights to act on the LLC’s behalf. Because he had no right to act on behalf of the LLC, the dissociated member could not use federal bankruptcy law to create rights stripped away under state law.

What does this mean for Washington LLCs? LLC members should have a frank discussion with one another, as well as their attorney, about how they want to handle the personal bankruptcy of a member when it is a hypothetical scenario – before anything goes wrong – and address the issue in their LLC agreement.

Photo credit: bootbearwdc on Flickr

This post is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting with an attorney.

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