By Contributor,Jay Adkisson

Copyright forbes

Counterintuitive things happen in bankruptcy.

When drafting LLC operating agreements, lots of planners include clauses to the effect that if a member lands in bankruptcy, that member will be dissociated (thrown out) of the LLC. This, they tell their clients, will protect the LLC interest from becoming part of the debtor’s bankruptcy estate. But does that really work?

The answer is found in the opinion from an Oregon bankruptcy case, Pearce v. Woodfield (In re Woodfield), 602 B.R. 747 (Bk.D.Ore. May 16, 2019).

The Debtor owned 50% of a number of LLCs known as the “Subject LLCs”. The other 50% owner was Pearce. All the Subject LLCs, which were subject to Oregon law, had operating agreements that were substantially identical. These operating agreements provided that if a member of the LLCs filed or was forced into bankruptcy, then the bankrupt member would be immediately dissociated from the LLC and no longer will receive distributions. Instead, the bankruptcy now-former member will be entitled to receive only a fixed amount of money, being his capital account balance paid over four years.

Debtor filed a voluntary Chapter 11 bankruptcy petition. Pearce then brought an adversary action in the bankruptcy to declare that Debtor had been disassociated from the Subject LLCs, which of course would have benefitted Pearce since then he would have taken 100% of the Subject LLCs. Debtor opposed Pearce’s attempt and Pearce then moved for summary judgment.

In opposition, Debtor argued that the disassociation clauses found in the operating agreements of the Subject LLCs were so-called ipso facto clauses. Basically, an ipso facto clause is any provision that attempts to eliminate or modify a debtor’s property rights upon the filing of bankruptcy. The Bankruptcy Code invalidates ipso facto clauses in three places:

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First, § 541(c)(1) invalidates ipso facto clauses in contracts and the like, plus any state law which empowers such clauses;

Second, § 365(e) invalidates ipso facto clauses in executory contracts, which will get to further down; and

Third, § 363(l) allows the trustee to continue to use leased and similar property that is subject to ipso facto provisions.

The Court noted that when Debtor filed for bankruptcy, a bankruptcy estate consisting of Debtor’s property was created and Debtor’s interests in the Subject LLCs became property of that bankruptcy estate. When this happened, the disassociation clauses in the operating agreements of the Subject LLCs were invalidated as ipso facto clauses:

“It seems self-evident that the dissociation provision in the Operating Agreements effects a modification of the Debtor’s interest in the Subject LLCs by ending his right to participate equally in distributions. * * * Moreover, the dissociation process is conditioned on Debtor’s commencement of a bankruptcy case, the precise situation that § 541(c) is intended to address.”

Thus, despite those disassociation clauses, Debtor’s bankruptcy estate remained a 50% member of the Subject LLCs. But what was the effect of that? The Court next turned to whether Debtor retained his governance rights as a manager of the Subject LLCs. Here, Pearce argued that, even if the Debtor’s bankruptcy estate retained the Debtor’s economic rights in the Subject LLCs, the Debtor still lost his governance rights, i.e., the right to manage the Subject LLCs on a day-to-day basis.

The Court held that Debtor could not be divested of his management rights under either the operating agreements or Oregon law as a result of his bankruptcy filing because such would be ipso facto provisions invalidated by the Bankruptcy Code. Aside from that, the Subject LLCs were designated as member-managed LLCs and the Debtor was a member. This required further analysis:

“The management structure is relevant because it determines the source of Debtor’s management rights. In a member-managed LLC, all members have equal management rights, absent a contrary provision in the operating agreement. * * * In contrast, in a manager-managed LLC—such as the Subject LLCs—members have no management rights other than to vote on the selection of the manager(s).. * * * Thus, a manager may be appointed through an agreement that constitutes an executory contract (thus implicating the ipso facto provision of § 365(e)); or, a manager could be appointed via some other process that does not involve an executory contract.”

Since the evidentiary record did not explain how Debtor became a manager of the Subject LLCs, the Court would defer its ruling on this issue until a later time.

The Court then moved on to one of the most interesting parts of this opinion, which was whether the trustee of the Debtor’s bankruptcy estate (which at this time was still the Debtor as the “debtor in possession” of the Chapter 11 estate) could assume or reject the operating agreements as “executory contracts” under Bankruptcy Code § 365.

To keep this simple, an “executory contract” is a contract which is basically open in the sense that a party must do something to obtain the benefit of the contract. The easiest example is a lease: To get the benefit of the lease, you have to make the required payments. Bankruptcy law, at § 365, essentially gives the trustee of the bankruptcy estate the right to either accept an executory contract (meaning that the trustee will have to render performance to get the benefit) or can reject the contract and forfeit the benefit. It’s the trustee’s choice.

By contrast, with a non-executory contract, nothing remains to be performed to receive the benefit. An investment into a mutual fund is an example of this: You have already paid your money and now need to do nothing more to receive cash distributions. Because nothing remains to be performed, non-executory contracts do not need to be accepted or rejected but simply become part of the bankruptcy estate.

Here, Pearce sought a declaratory judgment that the operating agreements had already been rejected by the bankruptcy estate, but the Court noted that no such action had taken place since Debtor’s reorganization plan had neither been confirmed nor rejected by the Court so far.

Pearce also sought a declaratory judgment that the operating agreements of the Subject LLCs were executory, and the Court next took up that issue. With LLCs and partnership agreements, it is not an easy issue because not all such agreements are alike nor do they invariably act in the same way. Some operating agreements are executory and some are non-executory. Which category they fall in to depends on what the member is required or not required to do under their terms.

The operating agreements for the Subject LLCs imposed various duties upon the members, including to manage the business and affairs of the company and to respond to capital calls, i.e., to put in additional cash as required. These are ongoing and continuing obligations which, if the member did not meet them, the member could be disassociated from the Subject LLCs and thus lose the right to distributions. Thus, the operating agreements of the Subject LLCs were in the nature of executory contracts.

But were the operating agreements capable of being assumed by the trustee of the bankruptcy estate? State laws (including Oregon’s) generally allow the assignment of LLC and partnership interests, but the assignee would not become a member until accepted by the other members. However, both Oregon law and the operating agreements of the Subject LLCs provide that they do not have to accept performance from an assignee without their consent. In other words, Pearce could force the trustee to reject the operating agreements even if they were executory.

Notably, the Court warned Pearce that the consequences of forcing this rejection might not necessarily be favorable to him: “Of course, Mr. Pearce is free to withhold his consent for any or no reason, but he may want to carefully consider the hazards of forcing Debtor to reject the Operating Agreements.” Without saying it in so many words, the import of this warning was that if the operating agreements were rejected, that might cause the operating agreements to be treated the same as if they were non-executory which, because of the Court’s ruling as to the ipso facto issues, might put Pearce into a worse position than if the Debtor accepted the operating agreements, i.e., Debtor’s bankruptcy estate might end up benefitting from the interests in the Subject LLCs anyway, but without having to render performance.

What we get out of this opinion is that, at least in bankruptcy, a lot of the fancy drafting that planners do to force the disassociation of a debtor member is just so much wasted ink. Maybe that works outside of bankruptcy, but it doesn’t work within bankruptcy because of the prohibition against ipso facto clauses.

We also get out of this opinion that the executory/non-executory issue under § 365 is extremely complicated and can lead to uncertain results at best. For planners, the determination of whether an executory operating agreement is desirable in comparison to a non-executory operating agreement requires thinking through several possible outcomes should a member land in bankruptcy. Suffice it to say that this determination will be very specific to the peculiar facts and circumstances before the planner. Suffice it also to say that few planners even think about these issues when drafting operating agreements because it is not then anticipated that a member will be in bankruptcy.

But members do go bust and they do land in bankruptcy from time to time, both voluntarily and involuntarily and the outcome determined by the operating agreement may then make all the difference in the world as to who is able to protect their position. Even from the debtor member’s viewpoint the issue can be complicated, since they may not want the interest to become part of the bankruptcy estate if it is a total liquidation bankruptcy, but may want the interest in the bankruptcy estate if it is a reorganization.

So, it is not only a very difficult issue to consider, but it is also potentially a moving target.

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