Limited Liability Company Interests as Property of a Debtor’s Estate Executory Agreements and the Conundrum of Section 365

Introduction
A companion article sets a scenario in which Debtor Inc. (“Debtor”) commences a case under chapter 11 of the U.S. Bankruptcy Code (the “Code”), and among Debtor’s assets is a membership interest in ABA, LLC (“Company”). The operating agreement of Company identifies various events as causing a “dissociation” of a member. One event is the commencement of a bankruptcy proceeding involving a member. Another event, in the case of Debtor, is Joe Smith ceasing to have day-to-day control over the business affairs of Debtor. The companion article addresses §541 of the Code, which applies when Debtor’s membership interest is reflected by a limited liability company (“LLC”) agreement that is non-executory, and surveys cases analyzing whether an LLC agreement is executory or non-executory.

Under §541(c)(1), if the LLC agreement is not executory, both economic and non-economic rights attendant to the LLC interest will be property of Debtor’s estate, notwithstanding dissociation provisions by agreement or statute to the contrary.

Herein, let’s assume that the LLC agreement is executory, because the obligations of both Debtor and the other members of Company’s operating agreement are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other. If Debtor reorganizes with Joe Smith at the helm, does Debtor retain its full bundle of rights with respect to the LLC interest? What if a trustee is appointed to manage Debtor’s estate, and the trustee seeks to assign the LLC interest to a third party as part of a sale of Debtor’s assets?

In the case of an executory contract being held by a debtor’s estate, we move from the clarity in situations governed by §541 and enter the world of §365 – a world of contradiction and internal inconsistency. Indeed, the only clarity under §365 is that the question of whether the debtor in possession or a trustee can assume an executory contract and exercise the non-economic rights of the debtor in an executory contract is heavily dependent on non-bankruptcy, state law. However, what law to look to, and how that law is to be applied, is unclear. In contrast to §541, where it is a foregone conclusion that the trustee can assume a non-executory contract and invalidate ipso facto clauses affecting “an interest of the debtor in property…” due to the financial condition of the debtor, the commencement of a bankruptcy case, or the appointment or taking possession by a trustee, §365 contains critical limitations on that right of assumption and ipso facto clause invalidation. What those limitations are, and how those limitations are to be applied, remain the subject of judicial debate.

Section 365 of the Bankruptcy Code
In furtherance of the ultimate goal of chapter 11 of the Code to rehabilitate the debtor, subject to certain exceptions discussed herein, §365 allows a trustee to assume or reject an executory contract. Executory contracts, depending on the obligations that remain unperformed, can be benefits or burdens. As a result, the Code authorizes a debtor in possession or trustee to reject an executory contract where burdensome obligations can impede a successful reorganization. On the other hand, assumption of the executory contract may assist a debtor in avoiding liquidation or provide a trustee with a valuable asset for the benefit of creditors.

To obtain value for an executory contract, the trustee must be able to assign the contract to a third party. Of course, LLC operating agreements typically contain restrictions on transfers to third parties, and such transfers may implicate dissociation provisions of such agreements. Subsection (f)(1) of §365 seems to remove the bar to assignments:

(f)(1) Except as provided in subsections (b) and (c) of this section, notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease…

Moreover, §365(f)(3) appears to eliminate the effect of dissociation clauses triggered by assignments:

(3) Notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law that terminates or modifies, or permits a party other than the debtor to terminate or modify, such contract or lease or a right or obligation under such contract or lease on account of an assignment of such contract or lease, such contract, lease, right, or obligation may not be terminated or modified under such provision because of the assumption or assignment of such contract or lease by the trustee.

A critical limitation, prefaced in subsection (f)(1), reveals that §365(f) does not provide a free pass for assignments where operating agreements and/or applicable non-bankruptcy law provide otherwise. Subsection (f)(1) opens with the phrase “[e]xcept as provided in subsections (b) and (c) of this section…” Section (c)(1) provides:

(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if –

(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and

(B) such party does not consent to such assumption or assignment…

At first glance, this all seems simple enough. A trustee cannot obtain complete freedom to assign unless the trustee can assume the executory contract. A closer look at the language of these two subsections provides a glimpse into how perplexing §365 can be. Subsection (f)(1) explains that, subject to subsection (c), executory contracts can be assigned without regard to any contrary applicable law. Yet subsection (c)(1) bars assumption of an executory contract if applicable law would bar assignment. It would seem that the exception swallows the rule.

Before trying to resolve the conflict between subsections (f)(1) and (c)(1), it is appropriate to look at other sections.

Section 365(e)(1), which contains strikingly similar language to §541(c)(1)(B) examined in the companion article, may also invalidate ipso facto clauses that attempt to terminate or modify an executory contract on account of the financial condition of the debtor, the commencement of a bankruptcy case, or the appointment or taking possession by a trustee. Section 365(e)(1) provides:

Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on –

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;

(B) the commencement of a case under this title; or

(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.

Subsection (e)(2), however, provides that the invalidation of ipso facto clauses does not apply to an executory contract where “applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to the trustee or to an assignee of such contract or lease, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties[.]” §365(e)(2). This language is very similar – but not identical – to the language employed by subsection (c)(1), which speaks to excusing performance from, or rendering performance to, “an entity other than the debtor or the debtor in possession” as opposed to just “the trustee or [] an assignee.” Compare §365(c)(1) with §365(e)(2).

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Quick recap: §§365(f) and (e)(1) allow for free assignability of executory contracts, without regard to any contractual provision or applicable law that would prohibit assignment or alter the rights or obligations under the executory contract due to assignment, the financial condition of the debtor, the commencement of a bankruptcy case, or the appointment or taking possession by a trustee. However, §§365(c)(1) and (e)(2) remove that freedom of assignment and revive those ipso facto clauses where applicable law permits the non-debtor from dealing with anyone but the debtor.

What does this all mean? Is this just the Code giveth and the Code taketh away? There is no easy answer. In fact, many courts have thrown up their hands in despair attempting to reconcile various subsections of §365. The problem is with the repeated references to “applicable law,” which seem to say the same thing in different ways: (i) “notwithstanding…applicable law, that prohibits, restricts, or conditions the assignment,” §365(f)(1); (ii) where “applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession,” §365(c)(1); and (iii) where “applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to the trustee or to an assignee of such contract or lease,” §365(e)(2).

What is clear – and it’s not much – is that, to the extent the language of these subsections can be squared with that of the others, when confronted with an executory contract, a trustee must first determine whether he or she can assume the executory contract under (c)(1). If each of these three phrases means the same thing, the answer to that question would create a domino effect, determining the assignability of the executory contract under subsection (f) and the enforceability of any ipso facto clauses under subsection (e). The rules of statutory interpretation tell us that, if Congress intended for each of these three phrases to have the same meaning, Congress would have used the same language. So, in interpreting §365, “the use of different words…within a statute demonstrates that Congress intended to convey a different meaning for those words.” SEC v. McCarthy, 322 F.3d 650, 656 (9th Cir. 2003).

With this in mind, courts have dealt with §365 in several different ways. With respect to the interplay between §365(f)(1) and §365(c)(1), although courts have adopted various approaches to reconcile these sections, a majority of courts have seemed to accept that the “applicable law” referenced in each subsection refers to different “applicable law.” More specifically, it appears that “applicable law” referenced in §365(f)(1) represents a broad universe of non-bankruptcy law that prohibits or restricts assignment, while §365(c)(1) refers to a smaller subset of non-bankruptcy law. So if the “applicable law” under 365(f) is the entire universe of non-bankruptcy law that prohibits or restricts assignment, how much of that universe is swallowed by the black hole of §365(c)(1)? And what are we to make of the subtle language difference between §365(c)(1) and §365(e)(2)?

Given the similarities of §365(c)(1) and §365(e)(2), courts have conceded that they address interrelated concerns. Some courts basically ignore the slight distinction in the language, while others try to resolve it. The distinction certainly cannot be ignored. As originally enacted in 1978, the applicable law phrases in §365(c)(1) and §365(e)(2) were identical, both reading how §365(e)(2) currently reads: “applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to the trustee or to an assignee…” In 1984, Congress altered the language of section §365(c)(1), replacing “to the trustee or to an assignee of such contract or lease” with “to an entity other than the debtor or debtor in possession,” while leaving the language of §365(e)(2) intact. The 1984 amendment to §365(c)(1) would seem to be a clear directive from Congress that these provisions have some distinction. Nevertheless, some courts still see no meaningful distinction. See, e.g., Perlman v. Catapult Entertainment (In re Catapult Entertainment), 165 F.3d 747, 753 (9th Cir. 1999) (“[I]t is enough to note that § 365(e)(2)(A) expressly revives ‘ipso facto’ clauses in precisely the same executory contracts that fall within the scope of § 365(c)(1).”). The First Circuit views the distinction as obvious, and treating the two as covering the identical applicable law would lead to an absurd result:

[W]e think Congress contemplated in 1984 that section 365(e)(2) would permit a debtor or a debtor in possession to avoid automatic termination of his executory contract rights under the section 365(e)(2)(A) exception. Were this not so, an absurd result would eventuate: there would be no contractual right left for a debtor or debtor in possession to assume under section 365(c)(1) because it would already have been terminated automatically under section 365(e).

Summit Inv. & Dev. Corp. v. Leroux, 69 F.3d 608, 613 (1st Cir. 1995) (emphasis in original).

In any event, courts have analyzed both §§ 365(c)(1) and 365(e)(2) in the same way, asking not just whether, but “why the ‘applicable law’ prohibits assignment.” In re Catapult Entertainment, Inc., 165 F.3d at 749. As the Ninth Circuit explained, “[o]nly if the law prohibits assignment on the rationale that the identity of the contracting party is material” will an ipso facto clause be given effect under §§ 365(c)(1) and 365(e)(2). Id. To reach a conclusion on these questions, courts choose between one of two tests: a hypothetical test or an actual test. The question is whether applicable law precludes a debtor, debtor in possession, or trustee from assuming or assigning an executory contract. The Third, Fourth, Ninth, and Eleventh Circuits have adopted the “hypothetical test,” based on a literal interpretation of the statute, under which the court determines whether applicable law bars assignment to a hypothetical third party under the circumstances before the court. The actual test, adopted by the First and Fifth Circuits, applies only when the debtor actually seeks to assign an executory contract. Neither test is entirely consistent with the statutory language, and the controversy on the right approach continues to play out.

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The lack of any consistent or uniform understanding of §365 has led courts down different paths. A couple of case summaries taking differing views on the “applicable law” illustrate the point:

In Milford Power Co., LLC v. PDC Milford Power, LLC, 866 A.2d 738 (Del. Ch. 2004), the company and its majority owner (“Milford Power”) filed an action against the minority owner, PDC Milford Power, LLC (“PDC”), to enforce a provision in the parties’ operating agreement, which worked to render PDC a “Withdrawn Member” by virtue of PDC’s voluntary bankruptcy filing. In authoring the opinion, Vice Chancellor Strine did not hide his frustration with §365, recognizing that the case law interpreting §365 is “confusing,” “in conflict,” and “murky.” Id. at 749, 755. Vice Chancellor Strine resigned to “endeavor to describe the parties’ contending positions and to render a sensible, if by no means inarguable, decision.” Id. at 749. Confronted with Milford Power’s contention that the Bankruptcy Code has no preemptive effect on the ipso facto clause in the operating agreement or §18-304 of the Delaware LLC Act – which provides that “[a] person ceases to be a member of a limited liability company upon…“fil[ing] a voluntary petition in bankruptcy,” (6 Del. C. § 18-304) – and PDC’s argument that §365 entirely preempts the ipso facto clause and the Delaware LLC Act, the chancery court reached a “more nuanced conclusion.” Id. at 757. Applying the Third Circuit’s hypothetical test, the court questioned “whether the Delaware LLC Act excuses the members of Milford Power from accepting performance from an assignee of PDC’s membership interest.” Id. at 758. The court found that it did, in part. Vice Chancellor Strine explained that the “applicable law,” the Delaware LLC Act, excuses members from “accepting substitute performance of governance rights and duties,” but members are not excused from accepting an assignment of another member’s “bare economic rights as an equity owner.” Id. at 760. Therefore, the court held that §365(e)(1) barred enforcement of the ipso facto clause and §18-304 of the Delaware LLC Act to the extent that Milford Power sought to deprive PDC of its economic rights in the company, but PDC’s governance rights fell outside the scope of §365(e)(1), and within the exception covered by §365(e)(2). Vice Chancellor Strine recognized that he left “the parties with a more complex outcome,” id. at 761, but reasoned that the distinction he drew “recognizes that it is far more tolerable to have to suffer a new passive co-investor one did not choose than to endure a new co-manager without consent.” Id. at 760.

Construing similar language under the North Carolina LLC Act, the U.S. District Court for the Eastern District of Pennsylvania, in Allentown Ambassadors, 361 B.R. 422 (E.D. Pa. 2007), reached a different conclusion. In that case, a minor league baseball franchise, which was a member of a league organized as an LLC, filed a bankruptcy petition that, the league argued, resulted in the dissociation of the debtor’s membership in the LLC under the operating agreement and applicable North Carolina law, rendering the debtor an assignee with no management rights. Having considered several provisions under the North Carolina LLC Act, which provided that interests in an LLC were “assignable in whole or in part” but only entitled an assignee to “the distributions and allocation to which the assignor would be entitled but for the assignment,” the court found the LLC membership interests under “applicable law” to be “somewhat assignable.” 361 B.R. at 448-49. Unlike the court in Milford Power Co., LLC v. PDC Milford Power, LLC, the court in In re Allentown Ambassadors found that application of §365(e)(2) “requires a clear, unambiguous prohibition against assignment…,” and this partial prohibition did not meet that standard. Id. at 454 (citation omitted). In effect, it must be clear that the identity of the debtor party was critical to the non-debtor party. Thus, the court declined to enforce the ipso facto provision of the parties’ operating agreement, as precluded by §365(e)(1).

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The issues raised in this article just scratch the surface of the difficulties embedded in §365. It is simply impossible to catalog all of the inconsistencies in §365 and list the various ways (and reasons therefor) that courts have tried to deal with them. The purpose of this article is not to provide clarity on §365, but merely to highlight the dilemmas contained within §365 and contrast its application with the simple, straightforward analysis that one would confront with a non-executory contract under §541. If your head is spinning after reading this article, then I have done my job.

Joshua R. Elias is a Director of Gibbons P.C., based in its Newark, NJ office, and a member of the firm’s Business & Commercial Litigation Department.