If you read an operating agreement for a closely held business, it is common to find “termination on bankruptcy” language. Essentially, these contract clauses provide that a person’s interest in the business is dissolved upon filing bankruptcy. These contract provisions are designed to protect the other shareholders/members in the event one of them files bankruptcy. However, the bankruptcy code will likely trump the contract provision and, therefore, the bankruptcy Court will still have control over the person’s partial interest in the business.
First, the bankruptcy code specifically provides that a person does not lose their interest in property simply for filing bankruptcy (Section 541(c)). Further, an executory contract cannot be voided simply for filing bankruptcy (Section 365(e)). Ultimately, federal bankruptcy laws will trump the contract provision.
If the person’s interest in the business remains, the bankruptcy Trustee can then step into the shoes of that person. The Trustee can exercise any rights under the contract, including selling the person’s partial interest or even forcing a liquidation of the entire company. Naturally, that is a burden on the business and all of the shareholders/members.
Anyone involved in the ownership of a business should carefully review their operating agreement or other contracts with a business bankruptcy attorney prior to making the decision to file a bankruptcy case.