LLC Interests and a Member’s Bankruptcy, Part V

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

We are considering the nature of the economic and noneconomic rights of a member of a limited liability company and whether, if the member enters bankruptcy, the bankruptcy trustee acquires those rights.  As explained in Parts III and IV, the member’s economic rights are property rights that belong to the bankruptcy estate in accordance with Section 541 of the Bankruptcy Code, but the member’s noneconomic rights are contractual in nature and, therefore, are potentially subject to Section 365 of the Bankruptcy Code, under which the trustee must assume an executory contract and comply with its conditions in order to exercise the rights it affords. One of the leading bankruptcy cases to address the question is In re Ehmann, 319 B.R. 200 (Bankr. D. Ariz. 2005):

While the parties disagree on several relevant legal principles, a dispute that is absolutely central to the motion to dismiss is whether the Trustee’s rights are governed by Bankruptcy Code § 541(c)(1) or by § 365(e)(2). In a very general sense, the latter provision, if applicable, permits the enforcement of state and contract law restrictions on the Trustee’s rights and powers, whereas the former provision, if applicable, would render such restrictions and conditions unenforceable as against the Trustee. Because § 541 applies generally to all property and rights that the Trustee acquires, whereas § 365 applies more specifically to executory contract rights, the answer to this question hinges on whether the Trustee is asserting a property right or an executory contract right.

Significantly, the Ehmann court treated the LLC operating agreement as equivalent to a partnership agreement:

If a partnership relation entails both executory contract rights and nonexecutory property rights, then it would seem to necessitate a threshold determination of which kind of rights are at issue for the particular kind of relief a Trustee seeks with respect to a partnership or LLC.

The court went on to hold that LLC’s operating agreement was not an executory contract because the debtor had no unperformed obligations and, therefore, under the particular facts of that case, Section 365 did not apply and the trustee acquired all of the member’s rights, both economic and noneconomic.

In 2010, the Bankruptcy Appellate Panel of the Ninth Circuit Court of Appeals addressed the question in In re First Protection, 440 B.R. 821 by considering whether the operating agreement of a limited liability company owned by the debtors was an executory contract.  The court concluded that it was not because the only two members were spouses who had filed a joint petition in bankruptcy and, according, there was no other person to whom the debtors could owe an unperformed obligation or who could owe an unperformed obligation to the debtors.  In that situation, the trustee “steps into the shoes of the debtors.”

There are other cases in which the courts considered whether an operating agreement was an executory contract and, for various reasons, concluded it was not.  But that is not always the result.  An illustrative example is In re Devries, No. 11-43165-DML-7 (Bankr. N.D. Texas 2014), in which the operating agreement obligated the debtor

  • to devote as much time to the company as necessary for its operation,
  • to respond to capital calls, and
  • to guarantee the obligations of the company upon request.

The court held that the ongoing obligation to devote time to the company was not sufficient to render the operating agreement an executory contract (particularly where there was no evidence that the debtor had actually devoted time to the company), but both the obligation to contribute capital and the obligation to guarantee obligations of the company were each sufficient.  Accordingly, because the trustee did not assume the operating agreement before the deadline imposed by the Bankruptcy Code, the trustee did not acquire the debtor’s noneconomic rights.

In Part VI, we will consider some other court decisions that do not follow the approach of In re Ehmann and In re First Protection, including In re Lee, the decision that started this discussion.


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