How State Supreme Court Ruling Could Affect Your LLC
by Brad Duncan
On September 10, 2015, the Washington Supreme Court decided Northwest Wholesale, Inc. v. Pac Organic Fruit, LLC, et al., Case No. 90891-5.
Though the Northwest Wholesale opinion’s exploration of the relationship between the federal Bankruptcy Code and Washington’s Limited Liability Company Act (the “LLCA”) can leave a reader (and particularly a lay reader) a bit glassy-eyed, at its core it addresses a common problem that for years has generated practical problems in administering a limited liability company – what happens when a member files for bankruptcy?
From a state perspective, Washington law (like the law of most states) gives a clear answer to that question. Washington’s LLCA says that, unless the parties agree otherwise, a member who files for bankruptcy stops being a “member” as a result of the filing and is “dissociated,” or removed, from the limited liability company. Because of this dissociation, the bankrupt party loses all management rights or interests in the LLC and is left with bare economic rights – nothing more, really, than the right to receive distributions if and when they occur.
On the federal side, though, the Bankruptcy Code arguably says something different. Several provisions of the Bankruptcy Code (referred to in bankruptcy parlance as “ipso facto” provisions) are intended to protect a party’s right to file for bankruptcy. Generally speaking, they do this by invalidating state law to the extent it tries to penalize a party or alter a party’s rights because the party has filed for bankruptcy.
The question in Northwest Wholesale was, which statute wins? Do the federal ipso facto provisions in the Bankruptcy Code trump (or, in legal terms, “preempt”) the dissociation language of Washington’s LLCA? Or does Washington’s LLCA continue to be effective despite these federal ipso facto provisions, so that a member of a Washington LLC who files for bankruptcy actually does lose its status as a member, and with it any right to participate in the affairs of the LLC?
The Washington Supreme Court’s answer was that the Bankruptcy Code does not preempt the LLCA. After Northwest Wholesale, at least in Washington courts, a member who files for bankruptcy will be dissociated. Though the Court’s textual analysis was fairly involved, the holding turned upon two basic concepts: 1) while a bankruptcy is a federal proceeding, and federal law defines the scope of the property that will be included in a bankruptcy estate, state law defines what that property actually is; and 2) the dissociation provisions of Washington’s LLCA merely define, as a matter of state law, what a member’s “interest” is – what it includes or doesn’t include – and it does not include the right to be a member of an LLC if that party has filed for bankruptcy. This state law-defined property is what flows into a bankrupt’s estate. The Court also emphasized that Washington law particularly protects the “associational” rights of LLC members. By investing in an LLC, the members of the LLC choose to do business with one another. When one of the members files for bankruptcy, however, that member’s assets (including whatever rights it may have in the LLC) are automatically transferred to the bankruptcy estate. In Northwest Wholesale, the Court recognized that the other, non-bankrupt members of an LLC should not compelled to do business with strangers, like the estate of a bankrupt.
Though every state has a dissociation statute similar to the LLCA’s, Northwest Wholesale is the first state appellate-level opinion to definitively address this issue. It rejects (I believe properly) a body of federal bankruptcy court authority that answers the question the other way – that finds that the Bankruptcy Code’s ipso facto provisions do invalidate state dissociation statutes. While it remains to be seen how federal bankruptcy courts will respond to Northwest Wholesale, it certainly governs proceedings in Washington state courts and represents a significant development in this area of the law. From a practical perspective, it ought to figure into the planning process for every limited liability company organized in Washington, and should inform the response of the remaining members when a member files for bankruptcy.