There has long been a tension in the U.S. Bankruptcy Code between Section 541 ("Property of the estate") and Section 365 ("Executory contracts and unexpired leases"). Section 541 essentially provides that nearly everything the Debtor owns becomes part of the Debtor's Bankruptcy Estate upon the filing of the Bankruptcy Petition. Section 365 allows the Trustee to decide whether to terminate or go forward with certain open contracts and leases; however, and very importantly for us here, Section 365 does not apply if the contract is "non-executory", which is discussed further below.
This tension manifests itself in quite a few situations. For the purposes of those engaged in business and asset protection planning, it causes the most serious problems in the area of so-called "unincorporated entities" (think partnerships and LLCs), in which the Debtor has rights that arise from the Partnership Agreement or Operating Agreement, and those rights may be "executory" or "non-executory" depending on the situation.
To the average reader, this must already sound like a bunch of gobbledygook bankruptcy legalese. But to planners, the impact of this issue is dramatic, since it determines whether the Bankruptcy Trustee can take over an interest and "step into the shoes of the debtor" (and perhaps vote to dissolve some entity the debtor owns), or whether the Bankruptcy Trustee can instead be restricted by either state law or provisions in the Partnership Agreement or Operating Agreement -- it is a narrow distinction that can make a very big difference not only for the Debtor in bankruptcy, but also for the other partners or members who might otherwise have to deal on unfavorable terms with the Bankruptcy Trustee.
The issue came to a head in the case of Movitz v. Fiesta Investments LLC (In re Ehmann), 319 B.R. 200, 2005 WL 78921 (Bk.D.Ariz., 2005) ("The Court here concludes that because the operating agreement of a limited liability company imposes no obligations on its members, it is not an executory contract. Consequently when a member who is not the manager files a Chapter 7 case, his trustee acquires all of the member's rights and interests pursuant to Bankruptcy Code §§ 541(a) and (c)(1), and the limitations of §§ 365(c) and (e) do not apply.").
The Ehmann court allowed a Trustee to take over a Debtor's interest in an LLC which interest was effectively passive (there was nothing for the Debtor to do to continue to receive distributions), but indicated that if the Debtor's interest was active (the Debtor had to do affirmatively undertake some acts to gain entitlement to distributions) the Trustee would have been restricted by Arizona law and the terms of the Operating Agreement.
After Ehmann, and numerous later cases that adopted the Ehmann reasoning, those of us who practice in this area were pretty confident that this area of the law had more-or-less shaken out, and we could thereafter blissfully engage in planning for clients based on Ehmann. Then, along came the Denman case which I shall shortly discuss, in which at least one bankruptcy court has kicked a wheel off our Ehmann apple cart and knocked it over.
Readers need to understand one further point: The Bankruptcy Code and its supporting case law have little tolerance for clauses in agreements that are triggered by a party's insolvency or bankruptcy, and which are known as "Ipso Facto Clauses". A significant purpose of bankruptcy law generally is to give a Debtor a period of respite from this creditors, so that the Debtor (or the Bankruptcy Trustee) can commence an orderly winding-down of the Debtor's financial affairs. Ipso Facto Clauses are anethma to this purpose, since they can have the effect of instantly eliminating certain assets from the Debtor's ownership and thus defeat one of the goals of bankruptcy as well as deterring a Debtor from seeking bankruptcy. This very strong prejudice against Ipso Facto Clauses plays a large role in the Denman case of which I shall now relate.
Derek Denman was bust, so he and his wife Marie jointly filed a Chapter 13 bankruptcy petition in the Western District of Tennessee.
Denman owned a 70% interest in Opus Medical Management, LLC. Section 13.4 of Opus' Operating Agreement provided for a "Sale On Triggering Event", which here meant that when Denman filed for bankruptcy, any other member of Opus could exercise their option to purchase Denman's interest in Opus. The option was open for 60 days after the filing of the bankruptcy petition, and could be made by giving written notice to Opus that the option was being exercised.
Dr. Michael Rack was another member in Opus, a 25% member to be exact. Within the 60 days, Dr. Rack filed an "Emergency Motion to Lift Automatic Stay", so that he could exercise the option to purchase Denman's 70% interest.
Fighting to keep his interest in Opus, Denman objected to Dr. Rack's Motion on the ground that the option provision, Section 13.4, amounted to an impermissible "Ipso Facto Clause" (i.e., a clause that only becomes effective upon the debtor's bankruptcy) that is negated by either Section 365(e)(1) or 541(c)(1)(B) of the Bankruptcy Code, and that Denman's 70% interest therefore was and remained in his bankruptcy estate under Bankruptcy Code section 541(c)(1)(B) despite the 60-day option.
Dr. Rack retorted that the option did not fall under Section 365(e)(1) -- thus attempting to force the Court to consider whether the option was an "executory contract" or not -- but apparently did not dispute that the option died as an Ipso Facto Clause uder Section 541(c)(1)(B).
The Opinion of the Bankruptcy Court that follows resolves this issue, and in a way that may result in some consternation to planners.
If the options clause amounts to an "executory contract" under Section 365, then the options clause is valid and Denman's 70% interest in Opus did not become a part of his bankruptcy estate under 541 (and Dr. Rack could properly exercise the option and take Denman's interest). But if the options clause amounts to a "non-executory contract", then Section 365 doesn't apply at all, and Denman's 70% interest in Opus passes into his bankruptcy estate under 541 and is protected from Dr. Rack's option.
Denman's 70% interest in Opus passes into Denman's Bankruptcy Estate under Section 541, regardless of what happens on the resolution of "executory vs. non-executory" issue under Section 365. That is clear.
The real question is what the Trustee can do with Denman's 70% interest in Opus. If Section 365 does not apply, then the Trustee could theoretically assume all of Denman's rights under the Operating Agreement, which would include Denman's ability to vote to wind up and dissolve Opus, meaning that Denman's share of Opus' assets would pass to the Trustee -- and the other members of Opus wouldn't have any say about this result (and they may not want Opus dissolved).
Under Ehmann (which the Denman court arguably should have followed) the salient inquiry is whether Opus' Operating Agreement amounts to an "executory" or "non-executory" agreement. In a typical display of its genius, Congress turns these issues on whether a agreement is executory or non-executory . . . without telling us what an executory or non-executory agreement is. Therefore, the Courts look outside the Bankruptcy Code to case law, and here to case law that developed from a 1973 Minnesota Law Review article entitled "Executory Contracts In Bankruptcy that eventually came to be known as the "Countryman standard".
In legalese, the Countryman standard says something to the effect that if the contract has been so far performed by one party such that the full obligation to perform has arisen in another party, the contract is "non-executory". If that party still has to do something before the other party has to perform, the contract is "executory".
In English, the Countryman standard basically says that an executory agreement means that somebody must take some material action before they reap the benefit of the agreement, while a non-executory agreement means that not much more needs to be done before that same somebody gets their promised benefits. A way to think about this is that an interest can be active in the sense that somebody must undertake some activity to earn their payment (this would be executory), or it can be passive in the sense that their payment is coming in no matter what (this would be non-executory).
But as a predicate, there must be an "agreement" since Section 365 only applies to executory agreements. So, is an Operating Agreement an "agreement" under Section 365? Please clear the liquids from your mouth before reading the next paragraph that gives the answer.
The Denman Court answers this question in the negative -- that's right, an LLC's Operating Agreement is not the type of "agreement" contemplated by Section 365. In other words, Section 365 has utterly no application to the Operating Agreements of LLCs (or the Partnership Agreements of General and Limited Partnerships). Forget 365 entirely, sayeth the Denman Court, effectively meaning that a Bankruptcy Trustee can exercise all the Debtor's rights in a Partnership Agreement or Operating Agreement, including vote to dissolve the entity.
The Denman Court reaches this remarkable result through some contorted reasoning. Here, I will summarize what the Court said, but also add what a critic of the Court's decision might retort.
First, the Court points out that an "agreement" typically requires a party's assent to the terms, but with an LLC if a party becomes a member, then that party automatically becomes subject to the Operating Agreement if they did not negotiate it.
The critic would point out that the party does have a choice as to whether to become a member in the first place, and exercising that choice is the assent -- not too differently from a person who pulls up to a gas pump and starts to fill up, there is an implied assent to the terms of the sale and the price (if you don't want the terms and the price, go to another gas station). That a new member to a partnership effectively assents to the existing terms of a Partnership Agreement by joining the partnership has been an integral part of partnership law for centuries, and that law was explicitly carried over into the new LLC laws as well.
Second, the Court points out that since not all members are required to amend the Operating Agreement, there is no assent to the change by the minority members who did want the change. The critic would point out that the minority members assented to this possibility when they choose to become members.
Third, the Court puts a lot of weight on the fact that an LLC only needs one member, and that one member has nobody else to agree with. The critic would point out that while that is true, that is not the same with multiple-member LLCs (as here).
Fourth, The Court looked the requirement that LLC member respond to cash calls, even if they are unable to perform, as well as the requirement that the other members respond greater if another member fails to respond. Thus:
A single member LLC operating agreement does not have multiple members and, therefore, can satisfy neither the mutual assent element nor the exchange of consideration element of contract law. This simple problem highlights the underlying problem with considering LLC operating agreements as executory contracts because it demonstrates that LLC members are not contracting amongst themselves but instead are organizing and structuring a new entity to receive their contributions, whether cash, services to be performed, or otherwise. Applying contract logic, the single member LLC seemingly becomes an absurdity.
The critic would again point out that this rationale doesn't apply to multiple-member LLs and here Opus had multiple member.
Based on all these points, the Court then concluded that Operating Agreements are not "agreements" under Section 365, at least under the Countryman standard:
Based on the foregoing, the court finds here that Tennessee LLC operating agreements are not per se executory contracts governed by sec. 365 of the Bankruptcy Code because of their unique elements and features under state law that are inconsistent with contract law. Such operating agreements, for example, may lack mutual assent, consideration, and privity amongst the parties. Furthermore, a member's failure to perform under an LLC operating agreement does not excuse the other members' performance under the LLC operating agreement, which contradicts the Sixth Circuit and Countryman standards for executory contracts. Tennessee LLC operating agreements cannot satisfy the Sixth Circuit and Countryman standards for executory contracts, and, thus, Tennessee LLC operating agreements are not executory contracts as contemplated under sec. 365 of the Bankruptcy Code.
Aware that the Court's conclusion would raise eyebrows, the Court reflected that this area of law is at best confused, although the "overwhelming majority" had determined that LLC Operating Agreements were non-executory contracts under Section 365, at least three other courts had found that they were executive contracts. But these cases were just wrong:
In reviewing these cases, the court believes there may have been some confusion or difference of opinion as to the obligations, duties, and rights that existed under an LLC operating agreement. These courts determined that the existence of "executory obligations" that could be "breached" caused the agreements detailing these obligations to be executory contracts. However, these courts arguably failed to consider that executory obligations can arise under numerous types of legal instruments and not just ordinary contracts. Also, the executory obligations and hypothetical breaches discussed therein were not subject to ordinary contract law but rather to the LLC entity laws of their respective states. Unilateral executory obligations like those found in operating agreements are not executory contractual obligations under either the Sixth Circuit standard or the Countryman standard. These standards require bilateral future obligations and not merely unilateral obligations to contribute to the LLC entity. Furthermore, a member's breach or default of its duties and obligations under an LLC operating agreement does not necessarily excuse the future performance of other members. To qualify as an executory contract, the breach must excuse the other parties' future performance as discussed in the Countryman standard. These three courts apparently failed to fully consider that an LLC operating agreement is a distinct legal instrument apart from contract instruments.
With regard to Opus' Operating Agreement, the Court held that the only duty of the members was to make their initial contribution, after which they had little duties. Strangely, and although professing to have scrutinized Opus' Operating Agreement, the Court apparently missed numerous duties that the members had, turning a Nelsonian blind eye to the provisions creating duties that ran afoul of the Court's desired storyline. Thus partially blinded, the Court concluded:
These membership interests are personal property of the individual members analogous to shares of corporate securities. Mr. Denman's Membership Interest became property of the sec. 541(a) estate upon the filing of his Chapter 13 petition. 11 U.S.C. sec. 541(a). In conclusion, the LLC operating agreement here is not an executory contract and is more appropriately classified as a business formation and governance instrument; therefore, the Opus Operating Agreement here is not an executory contract under sec. 365, however, Mr. Denman's Membership Interest is sec. 541 property of the estate.
The Court then turned to Section 541, or more specifically to 541(c)(1)(B), which basically says that if a provision in an agreement is triggered by the insolvency or bankruptcy of the debtor, the Court may ignore that provision. Recalling that the debtor, Denman, was trying to fight off the attempt of Dr. Rack to exercise his option to purchase Denman's interest for $10,000, Denman argued that Dr. Rack's option was precisely the type of provision that is invalidated by 541(c)(1)(B) -- because Dr. Rack's option did not vest until Denman filed for bankruptcy.
This is the so-called Ipso Facto Clause, and the Court noted that such clauses are triggered by some external event (usually the filing for bankruptcy) and not by any normal operation of the Operating Agreement:
[I]t is well-established that ipso facto clauses are unenforceable as a matter of law under the Bankruptcy Code. This is because the whole purpose of filing for bankruptcy is to provide the debtor with a 'fresh start,' and enforcement of ipso facto clauses would punish debtors by negating this central purpose.... Section 541(c) provides that, despite a[ ] provision between the parties to the contrary, a debtor's interest becomes property of the bankruptcy estate upon the filing of a bankruptcy petition and the debtor does not lose the property due to its bankruptcy petition.
quoting In re W.R. Grace & Co., 475 B.R. 34, 152–53 (D.Del.2012).
Here, Dr. Rack's option to purchase Denman's stock only arose upon Denman's bankruptcy; thus, it constituted an impermissible Ipso Facto Clause. Since Dr. Rack was attempting to get relief from the Automatic Stay just to enforce this unenforceable clause, he loses, and the Court so ruled.
ANALYSIS
Critical to the understanding of this Opinion is the realization that Dr. Rack was going to lose under either Section 541 or 365. Both of those sections have Ipso Facto Clauses, as found in 541(c)(1), 365(b)(2) and 365(e). So, to borrow a phrase from Conflicts of Law, the tension in this case between 541 and 365 amounts to a "false conflict", since Dr. Rack's option was going to be invalidated as an Ipso Facto Clause in either case -- the upshot being that the Denman Court did not need at all to gratuitously take on the issue of whether an Operating Agreement is an executory or non-executory agreement under 365.
Thus, this decision makes a lot more sense if one just focuses upon the option nature of the provision in question, and that the option was triggered by Denman's bankruptcy filing. If the Court had just directed its attention to that, then this decision would likely be unremarkable.
The problem with this decision is the Court's conclusion to the effect that an Operating Agreement is not an "agreement" under Section 365. If that result is broadly adopted by other courts, it has the potential to create a lot of difficulties for LLCs where a member is in bankruptcy.
Professor Carter Bishop of Suffolk University Law School, who is widely regarded as one of the nation's experts on this area of the law, writes:
In my humble opinion, the primary issue with the Denman approach is the highly problematic BRC § 365 "assume/reject" executory analysis. That executory contract statute includes substantial protections for other LLC members who are not in bankruptcy. If the contract/operating agreement is “executory” then the trustee is presented with a BRC § 365 assume/reject analysis. That analysis severely limits the trustee’s “assume” power by linking it to a correlative right of the debtor under common law contract (not LLC statutory law) to assign the interest without the consent of the other members.
Of course, if the nature of the debtor’s contractual obligations under the operating agreement qua that member are not significantly imbued with unique personal services, then the trustee may “assume” and step into the debtor’s shoes under the operating agreement. When that happens the trustee may exercise any and all “rights” of the debtor. Stated another way, the personal service nature of the debtor’s personal services “duties” precludes the trustee from exercising the debtor’s “rights’ under the operating agreement.
So the “executory contract” nature of the operating agreement is critical to protecting other LLC members who would otherwise be saddled with the trustee as a member of the LLC during the pendency of the bankruptcy estate. I do understand that the “executory contract” characterization is imbued with policy ramifications designed to maximize the value of the bankruptcy estate. So, in close calls, I would expect a trustee to argue it may assume either because (i) the operating agreement is not an executory contract, for whatever reason, or (ii) even if so, the debtor’s duties under the operating agreement do not invoke unique personal services. For the most part, BRC § 365 analysis has proceeded under the second prong. The difficulty with Denman is that is impermissibly dismisses the prong two analysis in favor of a per se rule that the mixture of contractual and statutory membership duties means the operating agreement will never be an executory contract irrespective of the prong two analysis.
So where does Denman leave us? As a dear friend of mine once stated, “the water is over the gunnels and the alligators are in the swamp.” Such a per se conclusion means that the trustee will be free to exercise all the debtor’s rights while not being encumbered by the duties. If the trustee is sued for breach, the defense will be a default judgment for chump change as any other unsecured creditor or the trustee will simply perform if it increases estate value (e.g., make a contribution).
In my view, every agreement reflecting contractual duties (whether mimicking an LLC statute or not) should run the BRC § 365 gauntlet. So, I would read 365 very broadly to extend the policy protections built into the statute for other members of an LLC. I do predict that this is so important, just like 2704 estate tax applicable to limited partnerships, that if Denman is correct, many if not most manager-managed LLCs will simply form or convert to a limited partnership where the trustee may become a limited partner without doing any damage to the partnership. The problem is that non-managing members of an LLC have significantly greater rights then a limited partner but not necessarily any more duties.
Some time ago, Dan Kleinberger and I made an ABA presentation on this topic in Chicago. The presentation analyzed a different case (In re Ehmann) but expressed the same fundamental concern. Taken to its extreme, In re Ehmann would allow a trustee to assume the rights and ignore the duties. We are now at that extreme with an In re Denman proclamation that an LLC “operating agreement” is essentially “per se” not an executory contract. Even that debate was absent from In re Ehmann.
According to In re Denman, the operating agreement is per se not an executory contract. As a result, the trustee is not truly permitted to “assume” the debtors rights under BRC § 365 because that statute (and its assume/reject analysis) simply does not apply. Rather, I presume the trustee views the “rights” simply as property of the estate under BRC § 541 and the trustee owns that property. This makes Denman pernicious. It restates In re Ehmann in absolute terms.
The "Denman shift” away from BRC § 365 and toward BRC § 541 inevitably favors the trustee and disfavors other members of the LLC. For example, all debtor’s property becomes part of the state by operation of law under 541(a)(1) and 541(c)(1) makes clear that that property interest becomes part of the estate “notwithstanding” any “restriction or condition” on the transfer of that property. So, a trustee may argue that a membership interest subject to an option is a restriction or condition that may be ignored.
I agree with Carter: The Denman Court's holding that an Operating Agreement is not an "agreement" for purposes of Section 365 seems untenable.
Here, let me muse that this was a result-driven opinion, in the sense that the Bankruptcy Court likely thought it fundamentally unfair that Dr. Rack should be able to purchase Denman's 70% interest in Opus for a pittance -- the $10,000 -- and then looked for a way to get around that result. To get to where the Court could nix the option as an Ipso Facto Clause under Section 541, the Court had to circumnavigate around Section 365.
But instead of navigating around Section 365, the Court decided to simply knock it over entirely by holding that the Operating Agreement was not under Tennessee law an "agreement" for purposes of Section 365. In other words, the Court probably could have found a more narrow ground to avoid Section 365, instead of leaving us with this broad-brushed result, but did not take the time to do so.
Note that in most cases, so long as the option is close to the Fair Market Value of the interest, this 541/365 dispute might not even arise since a Trustee would probably be quite happy to cash out a debtor's interest in an LLC for something around Fair Market Value. Here, the Court doesn't tell us how much Denman's interest in Opus was worth, but we can surmise that it was much more valuable than the $10,000 provided for in the Operating Agreement.
As Carter alludes, the Denman decision, if it survives appeal and is accepted by other courts, has the potential to create significant problems for the other members of an LLC if one of the members lands in bankruptcy. If Section 365 never applies, then the Trustee will be able to take over all the rights that the debtor-member had in the LLC, even (presumably) if those rights were contingent upon the debtor-member first taking some other action as required by the Operating Agreement. In other words, it may be that the Trustee will be able to take the good without the bad in some situations, which of course may be to the disadvantage of the other members.
Carter's warning that the Denman Court's reasoning, such as it is, may be taken to apply with equal fervor to other partnership entities, is a somber one. Let's hope that other courts take a greater interest in the fundamentals of partnership and LLC law, as well as the rights of the non-debtor members, than the Denman Court below did.
Stay tuned. I'm sure that we're about to see some harsh criticism of the Denman decision from Carter and others who closely follow the laws of unincorporated entities.
CITE AS
In re Denman, 513 B.R. 720 (W.D.Tenn., July 24, 2014). Full opinion at https://chargingorder.com/opinion-2014-tennessee-denman-charging-order.html
This article at http://onforb.es/1AnT7et and http://goo.gl/aygDGe
