This article deals with three principal types of entities, including those that are closely held, that can be formed in Texas under the Texas Business Organizations Code (“TBOC”): partnerships, corporations, and limited liability companies (“LLC”).
How to Address the Transferability of Interests
Transferability of interests in closely held entities is a topic that should not only be discussed prior to formation of the entity, but should also be addressed by separate agreements. For a corporation, such separate agreements may be via Bylaws, Shareholder Agreements, or Buy-Sell Agreements. For an LLC, the separate agreement may be referred to as an Operating Agreement, Membership Agreement, or Buy-Sell Agreement. In a Partnership, the transferability of such interests will be addressed in the Partnership Agreement.
An entity’s owners need to govern and get along – and contractual agreements help support this as well as ensure a “meeting of the minds” regarding operations and interests. A stranger to the business can upset the apple cart and create problems among the owners that will adversely affect the business of the entity. Not only are there instances where an owner wants to sell his or her interest, but there are instances when an owner may experience financial hardships and a creditor may attempt to obtain ownership of said interest or the economic interest in said ownership interest i.e., the right to receive a distribution.
If the owners fail to address the transferability of their interests by separate agreement, then the TBOC will address such transfers. Unless addressed by a separate agreement, interests in corporations or the economic interests are generally freely assignable.Partnership and LLC interests cannot be transferred without the consent of the owners, but the economic interests are transferable and such consent is not required. That said, the assignee of such economic interest cannot participate in the governance of the entity nor exercise the rights or powers of a shareholder, partner, or member in the entity. Further, such owner of an economic interest cannot be held liable for the governance of the business.
Bankruptcy and Restrictions on Transferability of Ownership Interests
So, what happens when the owner of an interest in a corporation, LLC, or partnership files bankruptcy and there is an agreement restricting the transferability of ownership interests?
In a nonprecedential opinion, the Bankruptcy Appellate Panel (“BAP”) for the Tenth Circuit Court of Appeals in Malloy v. Kramer (In re Kramer), No. 21-005, 2022 Bankr. LEXIS 3331, 2022 WL 17176411 (B.A.P. 10th Cir. Nov. 23, 2022), addressed this very issue and decided that the bankruptcy trustee was bound by the agreement restricting the transferability of the debtor’s economic membership interests in an LLC.
The focus was on the wording of Section 541(c)(1) of the Bankruptcy Code which provides that a debtor’s property interests contemplated by the Code becomes property of the estate –
… any provision in an agreement, transfer instrument, or applicable nonbankruptcy law –
(A) that restricts or conditions transfer of such interest by the debtor; or
(B) that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.
Here, the trustee argued that Section 541(c) overrides state law and thus permits him to sell the LLC interest of the debtor.
The BAP disagreed and stated, “the Bankruptcy Code will not enforce contractual provisions that prohibit a debtor’s property from entering the bankruptcy estate.” Malloy, 2022 Bankr. LEXIS 3331, at *14.
In construing Section 541(c), the BAP stated that
Section 541(c)(1)(A) invalidates any restriction or condition that prevents a debtor’s interest from becoming property of the estate, and § 541(c)(1)(B) invalidates any clauses—including ipso facto clauses—to the extent they expressly or implicitly cause a forfeiture, modification, or termination of a debtor’s interest in property from entering the estate.”
Id. at *14-15.
As for Section 541(c)(1)(A), the BAP noted that
§ 541(c)(1)(A) is meant to protect the transfer of pre-petition personal property to the bankruptcy estate. The Transfer Restrictions here did not prevent the LLC Interests from becoming part of [the debtor’s] bankruptcy estate.
Id. at *15.
Further, as for Section 541(c)(1)(B), the BAP noted that the agreements
contain consent requirements, none of which violate § 541(c)(1)(B) because they are not triggered by a member’s insolvency and do not cause a forfeiture or termination of the LLC Interests. Because the Transfer Restrictions do not restrict the LLC Interests from entering the bankruptcy estate, we conclude they do not violate § 541, and are therefore enforceable against the Trustee.
Id.
For these reasons, the BAP upheld the provisions of the operating agreements of the LLCs restricting the transferability of the interests in the LLC and thus prohibited the sale of the debtor’s economic interests in the LLC.
And though this case concerned Oklahoma law, the TOBC permits the restriction of the transferability of interests and thus is instructive — but just as importantly, is non-precedential.
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