In a recent decision by the Tenth Circuit Bankruptcy Appellate Panel, the court held that a chapter 7 trustee could not sell an LLC membership interest pursuant to section 363 of the Bankruptcy Code because of a transfer restriction within the LLC operating agreement. Malloy v. Trak-1 Technology Inc. (In re Kramer), No. 21-005, 2022 WL 17176411 (B.A.P. 10th Cir. Nov. 23, 2022).

There, the chapter 7 trustee (the “Trustee”) filed a Notice to Sell Personal Property (the “Sale Motion”) seeking to either sell the LLC interests to a stalking horse purchaser, or conduct an auction in the event a competitive bid arose or a party in interest objected to the Sale Motion. The debtor, Kramer, objected to the Sale Motion, arguing each LLC’s operating agreement (the “Operating Agreements”) contained transfer procedures and restrictions (the “Transfer Restrictions”), with which the Trustee had not complied. The Sale Motion was also objected to by certain members of a related LLC who contended the proposed sale violated transfer restrictions in their operating agreements.

The Bankruptcy Court ultimately entered an order on the Sale Motion, holding that the Transfer Restrictions were enforceable under Oklahoma and bankruptcy law and applied to membership and capital interests alike. Thus, the Bankruptcy Court held the Trustee could not sell the LLC’s membership interests unless he had complied with the Transfer Restrictions.

The Trustee appealed. On appeal, the Trustee argued that section 541(c)(1) of the Bankruptcy Code overrides state law and permits the sale of membership interests otherwise prohibited by state law.  Section 541(c)(1) provides:

notwithstanding any provision in an agreement, transfer instrument, or applicable non-bankruptcy 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.

11 U.S.C. § 541(c)(1). 

The Trustee argued that section 541(c)(1)(A) invalidates the Transfer Restrictions contained in each operating agreement. The court, however, was not persuaded. It held: “Section 541(c)(1) does not invalidate any of the Transfer Restrictions. First, § 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 Kramer’s bankruptcy estate. Accordingly, the Transfer Restrictions do not violate § 541(c)(1).”  Kramer, 2022 WL 17176411, at *8.

The decision in Kramer is in line with numerous other cases holding that section 541(c)(1) operates merely to ensure that an LLC membership interest becomes property of the bankruptcy estate, but it does not override the restrictions in an operating agreement that would prevent the transfer of the LLC membership interests to a third-party.  As one court explained:

Under this section of the Code, a debtor’s interest in an LLC becomes property of the estate even though some provision of the operating agreement or nonbankruptcy law would otherwise prevent the transfer. Thus, the Trustee undoubtedly received the Debtor's entire interest in BMA Ventures even though provisions of the Operating Agreement purport to modify that interest if a member files for bankruptcy.

But § 541(c)(1) does no more than that. Section 541(c)(1) therefore does not provide authority for the Trustee to sell the estate’s interest in BMA Ventures free of the constraints of the Operating Agreement.

In re Minton, No. 14-91293, 2017 WL 354319, at *6 (Bankr. C.D. Ill. Jan. 24, 2017) (emphasis added) (internal citations omitted); see also In re Woodfield, 602 B.R. 747, 762 n.10 (Bankr. D. Or. 2019) (“Thanks to § 541(c), this provision of the LLC Act was superseded when the LLC interests came into Debtor's estate. But § 541(c) speaks only of what happens when property ‘becomes property of the estate;’ it does not address the mechanics of property leaving the estate.”); Caymus Ventures, LLC v. Jundanian (In re Jundanian), 2012 WL 1098544, at *6 (Bankr. D. Md. Mar. 30, 2012) (“By its plain terms, § 541(c) governs what interests ‘become [ ] property of the estate.’ Congress enacted § 541(c) to eliminate barriers to the transfer of property into the estate, and not to void restrictions on the transfer of property from the trustee to third parties. Simply stated, nothing in the language of § 541(c)(1) addresses, much less authorizes, the transfer by the trustee of assets that are subject to prohibitions or restrictions on transfer.”) (citations omitted); In re Todd, 118 B.R. 432, 435 (Bankr. D.S.C. 1989) (holding that section 541(c)(1) does not void any restrictions on the transfer of the property from the trustee, as successor to the debtor, to third parties); In re Shauer, 62 B.R. 526, 530 (Bankr. D. Minn. 1986) (same); In re Polycorp Assocs., Inc., 47 B.R. 671, 672 (Bankr. N.D. Cal. 1985) (concluding “§ 541(c)(1)(A) is intended to eliminate barriers to the transfer of property to the estate, and nothing more”).

Interestingly, the Trustee did not argue, and the court in Kramer did not consider, whether the LLC membership interests could be sold via section 365 of the Bankruptcy Code governing executory contracts. In a prior Bankruptcy Protector post entitled, “The Exciting (or Bewildering?) Intersection of Bankruptcy Code Section 365 and the Sale of LLC Membership Interests,” Jody Bedenbaugh noted: “If the debtor or trustee is successful in convincing the bankruptcy court that the operating agreement is executory, the debtor/trustee may argue that Section 365(f)(1) allows the debtor/trustee to assume and assign the operating agreement to a third-party buyer, notwithstanding the restrictions in the operating agreement and applicable law.”  As such, the Kramer decision and cases that follow its reasoning may not necessarily be a death knell to debtors seeking to monetize their LLC membership interests.