LLC Operating Agreement: Is A Purchase Option Enforceable Against A Bankrupt Member?

In re Denman, 513 B.R. 720 (Bankr. W.D. Tenn. 2014)

A chapter 13 debtor was a member of a limited liability company. Another member sought relief from the automatic stay in order to exercise a right to acquire the debtor’s membership interests pursuant to the LLC operating agreement.

The debtor (Denman) owned 70% of Opus Medical Management, LLC, a chapter 11 debtor (the LLC). A section of the LLC operating agreement provided that upon occurrence of a “Triggering Event” a member could be required to sell its interests to other members at an “Agreed Value.” Among other things, if a member filed bankruptcy, the other members had 60 days to give notice that they were exercising the option to purchase the bankrupt member’s LLC interests.

After Denman filed bankruptcy, another member of the LLC filed an emergency motion to lift the automatic stay for cause to permit exercise of his option to purchase Denman’s interest. Denman objected, arguing that applicable section of the operating agreement was an ipso facto provision that was invalid under Section 365(e)(1) (executory contracts) or Section 541(c)(1)(B) (property of the estate) of the Bankruptcy Code.

The court first considered whether the LLC operating agreement was an executory contract, and thus subject to Section 365 (which prohibits “ipso facto” clauses). It noted that under applicable precedent an executory contract is one that has material obligations left to be performed such that the failure of performance by either contract party would constitute a material breach that excused the performance of the other.

However, court emphasized that there must be a contract in the first instance. “Contract rights arise upon an offer, acceptance, and transfer of adequate consideration between at least two assenting parties… If these elements do not exist, a contract right does not exist and, thereby, an executory contract cannot exist.”

It described various aspects of an LLC operating agreement that led the court to the conclusion that it was not an executory contract, including the following circumstances where party assent is not required:

  • Under the LLC act a person who becomes a member of an LLC is deemed to have agreed to the operating agreement.
  • Unless the governing documents provide otherwise, amendment of the operating agreement does not necessarily require all members to agree.
  • An LLC may be formed by a single person.

Similarly, it reviewed the fact that a breach by one party did not excuse performance by the others (for example, the obligation to make capital contributions), and members are capitalizing an entity and not exchanging consideration among themselves. In effect, member obligations are unilateral obligations to the LLC, and not bilateral obligations among the members.

The court acknowledged that several other courts have determined that LLC agreements were executory contracts. However, in the court’s view these other courts based their conclusions solely on the fact that there were obligations remaining to be performed without addressing whether the operating agreement was subject to contract law in the first place.

Consequently, the court concluded that an LLC operating agreement is not a contract, and thus is not an executory contract subject to Section 365. Instead, the court characterized the LLC operating agreement as “a legal instrument that defines the membership interests and rights that each member holds in [the LLC].” And membership interests are personal property and became property of the bankruptcy estate upon filing. According to the court, this meant that Section 541(c)(1)(B) was applicable, which provides:

[A]n interest of the debtor in property becomes property of the estate … notwithstanding any provision in an agreement … that is conditioned on … the commencement of a case under this title, … and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interests in the property.

Denman contended that this provision invalidated the section of the LLC’s operating agreement that gave other members an option to purchase his interest for $10,000 upon his bankruptcy filing. The court agreed, commenting that it is “well-established” that ipso facto clauses are unenforceable (i.e. clauses that specify consequences that “arise by the fact of a bankruptcy filing itself and not by normal operation of the agreement”).

In this case nothing happened automatically upon the bankruptcy filing. However, it was sufficient that the filing triggered the ability of a non-filing member to remove Denman’s LLC membership interests from his bankruptcy estate without authorization or approval

The court concluded that the operating agreement provision forced a modification or forfeiture of Denman’s membership interests and thus was invalid under Section 541. Since the request for relief from the stay was to permit exercise of the option, and the option was invalid, the request was denied.

Note that the determination of whether an LLC operating agreement is an executory contract may have a variety of consequences. For example, if an operating agreement is considered an executory contract, an LLC member could argue that an agreement requiring additional capital contributions could not be assumed because it constitutes a contract for financial accommodations that cannot be assumed under Section 365(c)(2).

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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