Peering Through the Muck Again: Another Court Analyzes Whether LLC Operating Agreements are Property Interests or Executory Contracts

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We’ve previously focused here and here on the split in authority analyzing whether provisions in LLC operating agreements that automatically strip members of their membership interests upon a bankruptcy filing are unenforceable ipso facto provisions.  Whether an LLC operating agreement is viewed by the court as property of the debtor’s estate or an executory contract influences the analysis and the ultimate answer.  Some courts have analyzed LLC operating agreements as property of a debtor’s estate under section 541 of the Bankruptcy Code and conclude that federal bankruptcy law preempts any ipso facto clauses found in such agreements, making them unenforceable; other courts have analyzed LLC operating agreements as executory contracts and conclude they are subject to section 365’s general prohibition on ipso facto clauses and, in certain cases, its exception permitting ipso facto clauses to operate where “applicable law” protects the non-debtor party from being required to accept performance from an assignee. 

The Bankruptcy Court for the District of South Carolina in Campbell v. Hanckel (In re Hanckel), recently engaged in a very similar analysis of an LLC operating agreement, albeit in the context of a fraudulent transfer action.  There, to determine whether a prepetition transfer could be avoided under section 544(b)(1) of the Bankruptcy Code, the Bankruptcy Court first needed to determine whether the debtor’s LLC membership interests – which the debtor transferred prepetition to another member – constituted property of the debtor’s estate.

Hanckel Marine, LLC was a boat dealership owned by Richardson Miles Hanckel, III (known as “Milo”) and his father, R.M. Hanckel, Jr. (known as “Miles”), who each held a 50% membership interest in the company.  Milo and the founder of Scout Boats, Steve Potts, entered into a business arrangement to create the Sportsman’s Island Facility on Daniel Island, South Carolina, which would eventually become the new home of Hanckel Marine.  Before the facility could be finished, Milo defaulted on his obligations to Potts, in addition to other obligations owed to creditors.

In July of 2011, Milo entered into a dissociation agreement whereby he declared that (1) he was “voluntarily dissociating” from Hanckel Marine, (2) he was aware that, under the terms of Hanckel Marine’s operating agreement, the dissociation would result in the transfer of his ownership interest to the remaining member, Miles, and (3) the “sole consideration” to which Milo was entitled and expected to receive under the terms of the dissociation and transfer of ownership interest was the sum of ten dollars.  The dissociation agreement included additional representations where Miles acknowledged that he would pay, on behalf of Hanckel Marine, the ten dollars owed to Milo, and where Milo acknowledged receipt of the ten dollars.

Later that year, Potts and two of his companies – Potts Family Properties, LP and Sportsman’s Island, LLC – sued Milo in South Carolina state court and won a judgment for approximately $1.95 million.

In summer of 2012, Milo filed for chapter 7.  The chapter 7 trustee sought to recover the prepetition transfer of Milo’s 50% interest in an adversary proceeding against Milo, Miles and Hanckel Marine.  The defendants asserted that no transfer of a property interest had occurred because the membership interest in Hanckel Marine was an executory contract, and that claims under section 544(b)(1) may only lie against property of the estate.  The defendants argued that Milo materially breached the LLC operating agreement by failing to comply with his ongoing obligation to make capital contributions, and that Milo’s dissociation from the company merely represented the “favorable resolution” reached to release him from his material breach and not a transfer of a property interest.

The Bankruptcy Court disagreed.  Under the explicit terms of the LLC operating agreement, capital calls were required only upon the direction of 100% of the existing members.  Consequently, because Milo held a 50% membership interest in Hanckel Marine, Milo’s consent would have been required before the capital call could be made.  The Bankruptcy Court found no evidence in the record indicating that Milo had ever agreed with his father to make a capital call.  Furthermore, Milo’s father testified that he did not ask Milo to provide additional capital to the company and made no distinction between capital provided and loans made to the company.  Accordingly, the Bankruptcy Court could find no evidence supporting the existence of any ongoing obligations and concluded the operating agreement was not an executory contract.

The Bankruptcy Court next turned to state law, and noted that under South Carolina law, a “distributional interest in a limited liability company is personal property.”  Nothing in the operating agreement altered this state law, as the operating agreement specifically permitted the assignment of a member’s distributional interest.  Milo’s interests in Hanckel Marine consisted of his management and distributional rights.  Although Milo lost his management rights by dissociating himself from Hanckel Marine, the dissociation agreement effectuated a transfer of his distributional rights, or personal property, to his father, Miles.

Lastly, the Bankruptcy Court found unpersuasive the cases defendants cited in support of their conclusion that operating agreements are treated as executory contracts.  It distinguished on their facts two cases, Broyhill v. DeLuca (In re Deluca) and In re Daugherty Constr. Inc., where courts held that the operating agreements at issue should be treated as executory contracts, noting that neither of the cases involved an alleged prepetition fraudulent transfer of a membership interest and that, further, the latter of the two cases was limited to the chapter 11 context and, more narrowly, the context of assumption.  Ultimately, the Bankruptcy Court concluded that the prepetition transfer of the membership interest was an avoidable voluntary conveyance under South Carolina’s Statute of Elizabeth and determined that the appropriate remedy was to recover the membership interest transferred to Miles.

The Bankruptcy Court’s decision in In re Hanckel raises a number of interesting questions.  First, is the issue of whether a membership interest constitutes property of the estate for purposes of a fraudulent transfer analysis a binary one?  In other words, if the LLC operating agreement were an executory contract, would that have necessarily meant that the membership interests transferred pursuant to it could not qualify as property of the estate?  Although the question was framed this way by defendants, there is at least a plausible argument that the nature of the LLC operating agreement itself would not change the nature of membership interests transferred pursuant to the LLC operating agreement.  Further, if LLC membership interests are so clearly property of the estate under South Carolina state law, what is the purpose of analyzing the contribution provisions within the LLC operating agreement to determine whether they constitute material unperformed obligations?  Such an analysis appears to leave open the possibility that, in certain circumstances, material unperformed obligations could exist in an LLC operating agreement, thus qualifying it as an executory contract.  In turn, would this then mean that prepetition transfers of potentially valuable membership interests could, in those circumstances, avoid avoidance?  Furthermore, does the Bankruptcy Court’s distinction of Deluca and Daugherty Construction mean that a different analysis and, to wit, a different answer regarding the appropriate treatment of a debtor’s membership interest is warranted in the context of a fraudulent transfer action?  Unfortunately, as with our earlier forays wading through the “muck” of case law surrounding the appropriate treatment of a debtor’s LLC membership interests, there still appear to be no clear answers to any of these questions.

Jessica Liou is an Associate at Weil Gotshal & Manges, LLP in New York.