The debtors (Soderstroms) owned 50% of Plaza N 15 Partners, LLC. The bankruptcy trustee (Webber) proposed to sell the debtors’ interests in the limited liability company, and the owner of the remaining 50% (Buono) objected. The issue was whether the trustee could sell the entire interest including management rights, or just the debtors’ economic interests in the LLC; and as the case developed, whether the trustee could cause 100% of the interests to be sold. The bankruptcy court held that only a 50% economic interest could be sold, and a creditor (Horizons A Far) that was interested in buying the LLC interests appealed.
Initially the bankruptcy trustee filed a notice of intent to sell the full interests of the debtors, including both economic and management rights. After the bankruptcy court agreed with Buono’s objections, the trustee revised the proposed sale to include only the Soderstroms’ economic interests. The basis for the court’s decision was that (1) whatever interests the debtors had were subject to consent restrictions in the LLC operating agreement, and (2) in any event the trustee could not acquire the management interests because of constraints in Section 365 of the Bankruptcy Code.
In particular, the bankruptcy court found that the operating agreement was an “executory contract.” Under Section 365 generally there is a right to assume and assign executory contracts if certain conditions are met. However there is an exception if “applicable law excuses a party, other than the debtor, to such contract… from accepting performance from or rendering performance to the trustee or to an assignee of such contract.”
The bankruptcy court found that the operating agreement was an executory contract, and applicable law did not require the other member to accept the trustee or an assignee. As a result, the trustee could not assume the debtors’ management interests and only the economic interests could be sold.
The proposed buyer objected on the grounds that as a creditor it could compel the sale of 100% of the member interests. This argument was based on Section 363(h), which authorizes a trustee to sell both the bankruptcy estate’s interests and a co-owner’s interests where the debtor has “an undivided interest as a tenant in common, joint tenant, or tenant by the entirety” if (1) partition isn’t practicable, (2) the sale of all interests would realize significantly more than a sale of the estate’s interests alone, and (3) the benefit to the estate outweighs the detriment to the co-owner. After the bankruptcy court rejected this argument on various grounds, the proposed buyer appealed both the sale order and the order overruling its objections.
On appeal, the district court suggested that the proper test for determining whether the operating agreement was executory is the “functional approach” instead of the “traditional approach.” Under the traditional approach, both parties must have material obligations remaining under the contract. Under the functional approach, an agreement can be executory even if only one of the parties has remaining obligations if the assumption or rejection would benefit the estate.
Although the bankruptcy court apparently used the traditional approach, the district court upheld its decision since the district court concluded the operating agreement was an executory contract under either test.
The district court also emphatically rejected the argument that Section 363(h) authorized the trustee to force a sale of 100% of the LLC interests. It held that the interest of LLC members is similar to that of partners in a partnership, and is “wholly different than an undivided interest in property that co-owners own in a tenancy in common or joint tenancy.” They are not undivided co-owners simply because they own equal halves.
The proposed buyer also attempted to invoke a buy-sell provision in the operating agreement. The bankruptcy court rejected that argument since it was not a member and had no standing to invoke the provision. The district court agreed that the buy-sell provision applied only to sales between members, not sales to third parties.
The bottom line was that the trustee was able to sell only the economic interests, not the management rights of the debtors, and there was no basis for forcing a sale of 100% of the interests.
A key point in this case was the finding that non-bankruptcy law would excuse the non-debtor LLC member from accepting the trustee or an assignee in place of the debtors so that the trustee could assume the debtors’ rights under Section 365. (A typical example of this type of contract is an artist’s performance contract.)
In partnership law, which is carried over to limited liability companies at least to some extent, there is a theme that partners should not be forced to accept third parties as their partners over their objections. That apparently underlies the court determinations in this case.
However, note that this will not always be the result. Where the debtor LLC member is an investor, as opposed to an active participant that brings expertise and experience to the venture, a court is going to be more inclined to allow a sale of the entire LLC interest.
Vicki R. Harding, Esq.