In a bankruptcy context, issues arising from the forced transfer of partnership or membership interests in a closely held business are a frequently encountered by the practitioner. The relevant focus is upon the value, or lack of value, given in consideration for the transfer of interest. The terms of the instant agreement or applicable state statutes will be the key to unlocking the value given in exchange for the interest with reference to avoidance by the estate.
It is well established that certain preferential transfers from the debtor’s estate are subject to the avoidance provision of the Bankruptcy Code.[1]
Judge Carla E. Craig, Chief Judge of the United States Bankruptcy Court for the Eastern District of New York, recently examined these issues in the context of a summary judgment, providing a basis for the analysis of factually similar avoidance claims.[2]
Preference Claims under 11 U.S.C. § 547(b)
Bankruptcy statutes expressly allow a trustee or debtor-in-possession to avoid a transfer of the debtor’s interest in property when each of five elements is met.[3] The transfer is avoidable when (1) the transfer is made to for the benefit of a creditor; (2) the transfer is for or on account of an antecedent debt existing pre-transfer; (3) the transfer is made when the debtor is insolvent; (4) the transfer is made on or within 90 days before the filing of the petition; or, if the transfer is to an insider: within one year prior to the filing of the petition; and (5) the transfer enables the creditor to receive more than would have been distributed if (i) the matter had been filed under Chapter 7; (ii) the amount realized had the transfer not been completed; and (iii) the creditor received payment of the debt to the extent provided under the bankruptcy provisions.
The preference statutes seek to prevent unequal treatment of creditors with similar classes of claim with a goal in furtherance of an “equality of distribution among creditors” and “preventing the debtor from favoring one creditor" because of its insider status or otherwise over others by transferring property shortly before filing for bankruptcy.[4] The ability to avoid certain transfers made prior to filing also serves to discourage “a race to the courthouse during the slide into bankruptcy” by creditors to the detriment of those with similar claims.[5]
Fraudulent Transfers of Debtor’s Property under 11 U.S.C. § 548(a)(1)(B)
Similarly, a trustee or debtor-in-possession may to avoid a transfer of the debtor’s interest in property under a theory of constructive fraud upon the estate. In the context of the involuntary transfer of the debtor’s membership interest, the court must find that the transfer was for less than reasonably equivalent value and that the debtor was insolvent on the transfer date, or rendered insolvent by the transfer of the membership interest.
The Bankruptcy Code provides an ability to avoid fraudulent transfers by setting aside transactions that unfairly or improperly deplete the bankruptcy estate or dilute the claims of creditors against the assets of the debtor.[6] This section is designed to reach transactions that are not frauds; instead, any transaction made by a financially impaired debtor for less than an even exchange of value is vulnerable.[7]
Garcia v. Garcia (In re: Garcia), 494 B.R. 799 (E.D. NY 2013)
The controlling facts of Garcia’s expulsion are not unique and were based upon claims that he breached the LLCs’ operating agreements by distributing unequal shares of profits to himself, and diverting entity funds for his personal benefits.[8] Garcia’s two brothers were members of the LLCs with each having a pre-expulsion one-third interest in the two entities. [9] Pre-petition, Garcia admitted that he received approximately $ 715,000 in excess distributions from the LLCs.[10]
The LLCs adopted resolutions to expel Garcia based upon the breaches of fiduciary duty (supra) and falsification of certain business records.[11] The operating agreements did not specify the grounds needed for a member's expulsion, but did expressly set forth the rights of a dissociating member:
11.2 Rights of Dissociating Member. In the event any Member dissociates prior to the expiration of the term of this Agreement:
. . .
(b) if the Dissociation does not cause a dissolution and winding up of the Company under Article XII, the Company shall pay to the Member, within six months of such Dissociation, an amount equal to the value of the Member's Membership Interest in the Company, to be paid over a period not to exceed five years together with interest at the minimum rate necessary to avoid the imputation of interest under the [Tax] Code. The value of the Member's Membership Interest shall include the amount of any Distributions to which the Member is entitled under the Agreement and the fair market value of the Member's Membership Interest as of the date of Dissociation as determined by [BLANK][12] reduced by any damages sustained by the Company as a result of the Member's Dissociation.
(emphasis added).[13]
Post-expulsion, an involuntary Chapter 7 petition was filed against Garcia and his spouse and later converted to Chapter 11, with the Debtors acting as debtors-in-possession.[14] The Debtors brought an adversarial action claiming (a) preferential transfers of the LLC interests and seeking damages equal to the value of Garcia’s membership interests or the restoration of the membership interests, and (b) that the transfers were fraudulent and that his membership interests should be restored.[15]
In examining Garcia’s claims of preference, the Court determined, as a threshold matter, that the expulsion from the LLCs was a transfer of the debtors’ interests under bankruptcy law and thereby subject to avoidance.[16] The Court examined the consequences of the transfer of interests under state law and found no bar to avoidance as applied to prepetition terminations of contracts.[17]
The Court analyzed the effects of the expulsion and determined that it had no effect on the debts and obligation to the LLCs. The expulsion was for cause and “did not satisfy, in whole or in part, any debt owed” to the LLCs or members. In fact, the amounts owed by the debtor due to his pre-petition actions were the same as it was immediately prior his expulsion from the LLCs.[18]
Under the express terms of the operating agreement (supra), the transfer of the membership agreement, either by expulsion or voluntary agreement, would create an obligation to the debtor. Therefore, as the transfers were not for or because of an antecedent debt within the meaning of 11 U.S.C. § 547(b)(2), they were not avoidable under § 547(b).[19]
Similarly, the contractual agreement to pay the debtor the value of the transferred membership interest provides a basis for establishing “value” in exchange for the transfer, satisfying the requirements of 11 U.S.C. 548(a)1)(B). The court found that the Debtor’s pending state court actions to determine the method to be used in determining the value of the transferred interest supported a finding of “reasonably equivalent value” in this context.[20]
Conclusion
The facts in Garcia are distinguishable due to the express language utilized in the operating agreements that set forth a disassociating member’s remuneration for the value of the membership interest. Just as important was the factual admission that the debtor had been disproportionally advanced funds that presumptively created a negative value for his interests. Not every agreement will have these clearly distinct terms and conditions when a member is forced by financial conditions to abandon or tender their interests.
When following the analysis set forth by the court, it is important to recognize the import of the entity’s controlling documents and state statutes to determine if the instant transfer is “of value” or reflects a preferential transfer to the entity or other members to the detriment of the estate. Had the court not been able to isolate the expulsion and disassociation of the debtor from the obligations purportedly due to the entities, a far different result and windfall to the estate may have resulted.
While all transfers of membership interests may be subject to avoidance by the trustee or debtor-in-possession, the controlling factor remains an establishment of specific “value” received by the debtor in consideration for the transfer of interest. Express provisions, which establish a contractual value and a corresponding obligation to pay for the transferred interest, are vital to defending the transaction when challenged under our bankruptcy rules.
[1] 11 U.S.C.§ 544(b).
[2] Garcia v. Garcia (In re: Garcia), 494 B.R. 799 (E.D. NY 2013) (reconsideration denied).
[3] 11 U.S.C. 547(a)(b)(1-5).
[4] Berger v. IRS, 496 U.S. 53, 58 (1990).
[5] Velde v. Kirsch, 543 F.3d 469, 472 (8th Cir. 2008).
[6] Togut v. RBC Dain Correspondent Servs. (In re S.W. Bach & Co.), 435 B.R. 866, 875 (Bankr. S.D.N.Y. 2010).
[7] Id. at 876.
[8] Garcia at 804.
[9] Id.
[10] Id. at 805.
[11] Id.
[12] The “blank” in the Operating Agreements left unresolved the method of establishing the value of the member’s interest upon dissociation.
[13] Garcia at 805.
[14] Id. at 803.
[15] Id. at 803-804.
[16] Id. at 811.
[17] Id. at 812.
[18] Id. at 813.
[19] Id. at 813-814.
[20] Id. at 815-816.