The Texas Supreme Court is set to hear oral arguments this fall to clarify what the Fifth Circuit Court of Appeals referred to as a ‘muddy’ issue regarding whether or not a member’s interest in a Texas Limited Liability Company (LLC) is exempt from creditor claims in bankruptcy.
The question is one of state law and the Fifth Circuit chose to certify the issue to the Texas Supreme Court because state appellate court decisions have not addressed whether the Texas Business Organizations Code (BOC) creates a bankruptcy exemption for a member’s interest in a Texas LLC.
As it is, creditors have very limited rights when it comes to an individual’s interest in an LLC. The lawyers at MehaffyWeber extend the following discussion of exempt property in bankruptcy, a creditor’s access to an individual debtor’s LLC interests in a bankruptcy proceeding, and how the court’s decision could affect bankruptcy creditors going forward.
The Estate and Exempt Property in a Texas Bankruptcy
All legal and equitable interests an individual has in property when bankruptcy is filed must be included in the bankruptcy estate unless they are exempted. Property that is exempt from creditors’ claims is defined under state and federal law.
Chapter 7 bankruptcy filers can choose between federal or state law to determine which property exemption laws are most favorable. As creditors will readily attest, Texas property exemption laws are some of the most debtor-friendly in the United States. Property exemptions are found in Chapter 41 and Chapter 42 of the Texas Property Code.
The property interest in an LLC is not listed as exempt property in the statutes. Texas courts have repeatedly held that an interest in an LLC is non-exempt property. Yet, under current Texas law, a creditor is not entitled to seize a member’s interest in an LLC, and can only gain access to a member’s economic interest.
Creditors’ Access to an LLC Interest in Bankruptcy under the Texas Business Organizations Code
The ownership interest in an LLC consists of an economic right and a governance right. What the law has sought to do is balance the interests of other non-debtor LLC members in continuing to operate the business with the interests of creditors in the debtor member’s personal property. To that end, the BOC Section 101.002prohibits creditors from accessing LLC property or interfering with LLC governance.
The BOC Section 101.002 also recognizes charging orders as liens, and in fact makes them “…the exclusive remedy by with a judgment creditor may satisfy a judgment” against a judgement debtor’s membership interests. The lien entitles the creditor only to those financial distributions from the LLC to which the debtor becomes entitled. However, the creditor cannot foreclose the lien and has no other remedy.
Until 2023, a bankruptcy trustee could still seize the assets of an LLC that was 100% owned by the debtor. Effective in 2023, subsection (g) was added to BOC Section 101.112, applying the statute to both single-member and multi-member LLCs.
The Muddy Issue before the Fifth Circuit in Canada v. Sherman
In Canada v. Sherman, Mr. Canada filed for Chapter 7 bankruptcy and claimed that his 70% ownership interest in DAD Drilling, LLC was exempt from the bankruptcy estate under Texas law. Bankruptcy trustee Sherman objected to the claimed exemption.
The bankruptcy and district courts agreed with Sherman, as there is no explicit exemption for LLC interests in the BOC, and Texas case law has concluded that LLC interests are non-exempt property. The bankruptcy court agreed with Sherman.
Canada appealed to the U.S. District Court, which denied the appeal, affirming the bankruptcy court and noting that the Texas Property Cody also did not list LLC interests as exempt property. At issue for the Fifth Circuit, is whether section 101.112 of the BOC creates an exemption for LLC membership interests in federal bankruptcy proceedings. The Fifth Circuit had two options: (i) make an “Erie” guess on what the Texas Supreme Court might hold, or (ii) ask the Texas Supreme Court, by way of “certified question” to answer the matter. The Fifth Circuit opted for option 2, asking the Texas Supreme Court: “Is an LLC membership interest exempt property in a federal bankruptcy proceeding, based on section 101.112 of the Texas Business Organization Code?”
Section 101.112 gives a judgment creditor only the right to obtain a charging order and receive distributions that would otherwise go to the LLC member. The creditor cannot force distributions and may not obtain possession of or exercise legal or equitable remedies with respect to the LLC property.
Thus, if an LLC elects not to make any distributions during the term of a creditor’s charging order, the creditor has no legal ability to collect on the debt from LLC assets.
What the Texas Supreme Court May Decide and How it Could Affect Bankruptcy Creditors
No other state has gone so far as to declare a member’s interest in an LLC as exempt property in bankruptcy. Most states have laws similar to Texas that include an LLC interest in the bankruptcy estate and limit creditors’ access to charging orders.
Though some states have laws that allow a creditor or bankruptcy trustee to foreclose on a charging order if distributions don’t satisfy the debt, Texas Appeals Courts have consistently held that charging orders are the exclusive remedy by which creditors can satisfy a judgment from a debtor’s LLC interest.
The Texas Supreme Court may answer the question narrowly, or may change the scope of the question in its reply. It may also decline to answer, which is unlikely.
Whatever the response, it will have an effect on both state court collection cases and bankruptcy cases. It may also help inform investors on what corporate form to use when forming a business entity.
It Seems Unlikely that a Texas LLC Interest will Become Fully Exempt Property in Bankruptcy
Although Texas has not been shy about deviating from the rest of the country, it makes more sense that the Supreme Court will find the legislature intended to provide substantial protections for non-debtor LLC members and the livelihood of a debtor member while still providing creditors with some form of recourse.
Our bankruptcy lawyers at MehaffyWeber have considerable experience representing creditors in Texas and know how to navigate the Lone Star State’s debtor-friendly laws effectively.