SCOTUS: Objective Standard Wins Day in Violation of Discharge Injunction Litigation


First published in the Oregon State Bar Debtor-Creditor Newsletter Vol. XXXVIII, No. 2

Bankruptcy Law Abrogates Certain LLC Provisions – Ipso Facto and 11 USC § 365(c)(1)

Pearce v. Woodfield (In re Woodfield)
602 B.R. 747 (Bankr D. Or. 2019)

This opinion provides a thoughtful analysis of the intersection between the Bankruptcy Code and Oregon law governing limited liability companies (“LLCs”). The facts are straightforward. Chapter 11 debtor Blair Woodfield (“Debtor”) held a 50% membership interest in three LLCs. A gentleman named Parley Pearce held the remaining 50% membership interest in those LLCs. Each of the LLCs had substantially similar operating agreements (“OAs”). Pearce filed an adversary proceeding seeking a declaratory ruling that: (1) the Debtor ceased to be an LLC member when he filed for bankruptcy relief; (2) that the subject OAs were executory contracts that were rejected; and (3) the Debtor had lost his rights to manage the businesses of the Subject LLCs.

The court started its analysis by pointing out that LLCs are a relatively new type of business entity that became increasingly popular after the IRS clarified their tax treatment in 1998. As such, the Bankruptcy Code does not even mention LLCs. The court went on to explain that LLC membership interests are comprised of two general categories of rights – governance rights (e.g., voting and management rights) and economic rights (e.g., distribution rights, etc.). Oregon’s LLC statutes (ORS Ch. 63; the “LLC Act”) address both bundles of rights and set out certain default rules. Most notably here, the LLC Act provides that “if a member of a multi-member LLC files a bankruptcy petition, that member ceases to be an LLC member, but retains the ‘right to receive and retain ... the distributions, as and when made, and allocations of profits and losses to which the [member] would be entitled.’” Woodfield, 602 B.R. at 753 (quoting ORS 63.249(3)). In this case, the OAs modified the above default rule in one respect. The OAs provided that rather than retaining the right to participate in distributions, the disassociated member (i.e., the Debtor) would only receive a set amount of money (collectively, the “Disassociation Provisions”).

With this background in mind, the court unequivocally rejected the Disassociation Provisions as unenforceable ipso facto clauses. The court first discussed how Debtor’s membership interests became property of the estate under § 541(a)(1), triggering § 541(c)(1)(B). That subsection states –

     [A]n interest of the debtor in property becomes property of the estate ... notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law ... that is conditioned on the insolvency or         financial condition of the debtor, [or] on the commencement of a case under this title ... and that effects ... a forfeiture, modification, or termination of the debtor's interest in property. Id. at 755 (quoting 11 USC § 541(c) (1)     (B)).

Here, the Disassociation Provisions were specifically triggered upon the Debtor’s bankruptcy filing, and the court found it “self-evident” that they modified the Debtor’s economic rights by ending his ability to participate equally in LLC distributions. Id. at 755 (adding that this is the “precise situation that § 541(c) is intended to address”).

Similarly, the court concluded that these unenforceable ipso facto clauses could not prevent the Debtor from exercising his general governance rights (i.e., voting).

Next, the Court discussed the LLCs’ management rights. The LLCs were manager-managed with the Debtor acting as manager. However, the record was unclear as to how the debtor actually became manager. The court noted that a manager could be appointed through an executory contract or by other means. Given that, the court left the door open for Pearce to seek relief at a later date and provide evidence that would allow the court to opine regarding whether the Debtor’s appointment as manager is modified in some manner by § 365 or another provision of the Bankruptcy Code.

Lastly, the court turned to the questions of whether the OAs were executory in nature and assumable by the Debtor. Although partnership agreements have often been found to be executory, LLC operating agreements are another creature entirely. An LLC’s operating agreement may simply outline the governance structure for its business without creating ongoing obligations for its members. After briefly discussing Professor Vern Countryman’s definition of executory contracts, the court indicated that there were two pertinent questions that determine whether the OAs are executory – “are there unperformed obligations [under the OAs], and would a breach excuse performance by the counterparty.” Id. at 758. The court then engaged in a fact-intensive review of the OAs and concluded that they were somewhat akin to partnership agreements (e.g., required members to hold meetings, devote time to the management of the company, required capital contributions, etc.). Ultimately, the OAs were held to be executory in nature.

However, the court went on to hold that the Debtor could not assume the OAs without Pearce’s permission. Pearce argued that the OAs were nonassignable personal service contracts under § 365(c). The court indicated that it did not need to determine if the OAs were nondelegable personal service contracts because § 365(c) applies much more broadly to contracts that are not assignable under nonbankruptcy law. Id. at 761 (citing Perlman v. Catapult Entertainment (In re Catapult Entertainment), 165 F.3d 747, 749-750 (9th Cir. 1999)). Under Oregon’s LLC Act, a member may assign his or her membership interest only if the remaining members accept the assignee as a member. As such, the OAs were not assignable over Pearce’s objection.

This case is not simply limited to an analysis of unique provisions in these LLC operating agreements. It can be analogized to stand for the general proposition that the LLC Act’s default provisions regarding the disassociation of bankrupt members will be superseded by federal bankruptcy law since those rules abrogate the member’s rights.

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