Can An LLC Interest Owned By A Debtor Be Sold By The Bankruptcy Trustee?

Forbes

30-04-2025

When individual debtor Larry Addington filed for bankruptcy, he owned a 36% membership interest in a limited liability company called Ultra Energy Resources, LLC ("Ultra"). In turn, Ultra owned a 100% membership interest in another limited liability company called Carbon Fuels Properties, LLC ("CFP"). After the case was converted from Chapter 11, a Chapter 7 Trustee was appointed for Addington's debtor estate.
Credit-bidding is a process by which a creditor participates in the judicial sale of a debtor's asset, but does not bring cash. Instead, the creditor offers to reduce (credit) the amount of money owed to the creditor in exchange for taking the debtor's former asset.
By the time of Addington's bankruptcy filing, a creditor by the name of Business Aircraft Leasing, Inc. ("BAL") had obtained a charging order lien against Addington's interest in Ultra. BAL had also asserted a claim for about $1.36 million against Addington's bankruptcy estate. Because with the charging order lien on it the Ultra interest was of dubious value to the Chapter 7 Trustee, BAL was allowed to credit-bid for and acquire the Ultra interest from the bankruptcy estate in a sale transaction that was approved by the bankruptcy court.
Assets sales occur all the time in the bankruptcy courts between creditors and trustees. Like every day and multiple times per day in every judicial district throughout the United States. What made this particular sale different, however, was that here the asset being sold was a debtor's interest in an LLC.
BAL, which was the creditor who held a charging order lien on the Ultra interest and had just purchased that interest from the Chapter 7 Trustee, apparently believed that when the interest was acquired that BAL also acquired the so-called "governance interests" ― these are the rights to manage the LLC and vote to admit other member or even to dissolve the LLC. Not so, said Ultra, the only thing that BAL purchased were the "economic rights" that basically means a right to distributions from Ultra.
Not being the least bit happy with this answer, BAL sought a declaratory judgment from the bankruptcy court that BAL had purchased all of Addington's 36% rights in Ultra, including both economic and governance rights. But Ultra fought back, moving for summary judgment with the argument that BAL only had acquired the economic rights, but not the governance rights.
All this resulted in a Memorandum Opinion by the U.S. District Court for the Eastern District of Kentucky in Business Aircraft Leasing, Inc. v. Ultra Energy Resources, LLC (In re Addington), 2025 WL 936686 (Bk.E.D.Ky., March 26, 2025).
The Court first noted that BAL was foreclosing on its lien against Addington's 36% interest in Ultra. Since that lien arose from the charging order, and the charging order only placed a lien on Addington's distributional rights in Ultra, the only thing that BAL was foreclosing upon was its lien in the distributional rights only. Thus, when the court entered the sale order for the liened interest, the only thing that the court could have ordered was a sale on the distributional interest.
Moreover, at the auction BAL credit-bid it's interest. For background, a credit bid is where a creditor does not bid cash at a judicial sale but instead bids a credit of all or some of the amount of its judgment for the asset being sold. When BAL credit-bid a portion of its judgment for the interest, it could only have bid for the Ultra interest subject to the charging order ― which, again, was only the distributional rights.
Moving on, the Court further noted that when BAL purchased the interest from Addington's bankruptcy estate at the auction, the Purchase Agreement stated that what BAL was buying was the "right to receive distributions" from the Ultra interest, not any additional rights. This was consistent with Kentucky LLC law which limits the rights of a charging order holder to a lien on only the distributional rights and further provides that only the distributional rights may be sold at a foreclosure sale. Kentucky law also specifically prohibits the purchaser at the judicial sale, unless admitted as a member to the LLC, from participating "in the management and affairs" of the LLC.
Finally, the Court looked to Ultra's operating agreement and noted that BAL could only be admitted as a member (as opposed to an assignee of Addington's interest) if and only if Ultra's managers consented to the purchaser at the judicial sale becoming a member. Since the Chapter 7 Trustee did not negotiate this with Ultra's managers prior to the sale, BAL did not become a member of Ultra merely by purchasing Addington's former interest. As a mere assignee of Addington's interest, BAL did not gain Addington's governance rights.
For all these reasons, the Court denied BAL's attempt to claim governance rights in Ultra.
ANALYSIS
There is an important question of first impression that is answered by this opinion, which is that if a bankruptcy trustee takes a debtor's interest in an LLC, and sells it, what does the purchaser of the interest get? There was speculation both ways: Some thought that the purchaser would get only the distributional rights as occurred here, while others thought that the purchaser might get the entire interest including governance rights.
To an extent, both are right. Unless prior to the sale the bankruptcy trustee negotiates with the LLC managers to admit the purchaser, the purchaser at the judicial sale will not be anything more than an assignee of the distributional interest as was the result in this case. However, if the bankruptcy trustee negotiates with the LLC to acquire the governance rights (and there may be other circumstances where the bankruptcy trustee takes the governance rights), then the full interest, including both distributional and governance rights, could be sold at the auction. In that latter case, the purchaser would become a full member in the LLC.
Note that the managers of a closely-held LLC are unlikely to admit the purchaser as a member, no matter how much the bankruptcy trustee negotiates, unless they know the purchaser will be friendly. If an LLC has a large number of members, such as a hedge fund with 90 members, however, then it might not be that big of a deal.
The result that the purchaser at the judicial sale ends up only as an assignee of the distributional rights, but without governance rights, is the result that will ordinarily be obtained outside of bankruptcy too.
From a debtor's viewpoint, this opinion is also proof positive that LLC and partnership interests owned by the debtor when the bankruptcy case is commenced can be lost through the bankruptcy proceeding. Because the sale of the interest is by the bankruptcy trustee's sale pursuant to federal bankruptcy law, a state law prohibition against foreclosure is probably not going to be a barrier. But we'll have to wait for another opinion to confirm that.