LLC Interests and a Member’s Bankruptcy, Part IV

[The other articles in this seven-part series are here:  Part IPart II, Part III, Part V, Part VI, Part VII.]

Although a bankruptcy debtor’s contract rights are within the definition of property of the estate under Section 541 of the Bankruptcy Code, they are different than most other property of the estate because they represent both a potential asset and a potential liability. As such, they are potentially subject to Section 365, dealing with executory contracts.  An executory contract is one in which some of debtor’s obligations under the contract remain to be performed and some obligations owed to the debtor by another party remain to be performed. The unperformed obligations must be significant enough that failure to perform them would constitute a material breach of the contract.

If a contract is executory, the bankruptcy trustee has two choices under Section 365:  to assume the contract or to reject it.  In many cases, after assuming an executory contract, the trustee will assign it to a third party in exchange for consideration (i.e., payment of money that is added to the bankruptcy estate).  However, the trustee may assume and assign an executory contract only if two conditions are fulfilled:  (1) any breaches of the contract on the part of the debtor must be cured and (2) the assignee who takes over the contract must be capable of performing the debtor’s obligations.  Generally, any contract provisions that prohibit the assignment are void, but there are exceptions.  For example, if another party to the contract to whom the debtor owes obligations has the right to refuse performance by anyone other than the debtor, the contract cannot be assumed and assigned over the objection of that party.

On the other hand, a rejection of the contract is treated as a total breach of the contract by the debtor, and the other party or parties may assert a claim for damages in the bankruptcy.  Rejection can occur either by the affirmative action of the trustee or by the trustee’s failure to assume the contract before the applicable deadline.

But what if the contract is not executory, for example because the debtor has completely performed all of his or her obligations under the contract?  In that case, Section 365 is not triggered, and the contract automatically becomes property of the estate with no need for the trustee to assume it.

As discussed in Part II, the Bankruptcy Court in In re Lee stopped with its conclusion that a member’s economic and noneconomic rights in a limited liability company become the property of the estate when the member files a bankruptcy petition.  Neither the Bankruptcy Court nor the U.S. District Court considered the possibility that the LLC’s operating agreement – i.e., the source of Lester’s membership rights in the LLC – might be an executory contract, in which case the trustee would not have acquired the right to exercise Lester’s voting rights until the trustee assumed the operating agreement.  Indeed, neither the debtor nor the LLC appears to have made that argument before either the Bankruptcy Court or the U.S. District Court.  However, there are other federal court decisions recognizing that principle and addressing its ramifications. We’ll see how those cases play out in Part V.


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