Peering Through the Muck: Court Analyzes Operation of Ipso Facto Provisions in LLC Membership Agreements Under Section 541 of the Bankruptcy Code

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Contributed by Sara Coelho

Some state statutes, as well as the governing documents of some organizations, provide a tidy split between a debtor and any limited liability companies in which it holds an interest by providing for the elimination of a debtor’s membership interests when it files a bankruptcy petition.  Such a divestiture is of course contrary to the Bankruptcy Code’s usual scheme, which protects and preserves estate property.  Debtors have argued that such statutory and contractual provisions are “ipso facto” clauses that modify or terminate contractual or property rights held by the debtors and are therefore pre-empted by provisions in the Bankruptcy Code, which generally invalidate them.  A recent case from an Arkansas bankruptcy court considered this issue from the angle of the debtor’s property right in its membership interest, in contrast to another body of cases that addresses the parties’ contractual rights to enforce such provisions in LLC agreements.  This is not by any means the first time that a court has undertaken such an analysis, but the case illustrates the simplicity of the question when the rights are considered as property rights under section 541 of the Bankruptcy Code, rather than as contractual rights under section 365.

In In re Dixie Management & Investment, L.P., the non-debtor members of an LLC sought a declaratory judgment from the bankruptcy court that, upon the debtor’s filing of its bankruptcy petition, the debtor ceased to be a member of Moberly Investment Group, LLC.  The Dixie debtor owned a 62% membership interest in Moberly, but under Moberly’s operating agreement, and by statute in Arkansas, Dixie ceased to be a member of Moberly as a result of filing for bankruptcy protection.

The court found that the debtor’s membership interests in an LLC became property of the debtor’s estate upon the debtor’s bankruptcy filing pursuant to section 541 of the Bankruptcy Code.  Specifically, section 541(c)(1) of the Bankruptcy Code provides that the debtor’s interests in property become property of the estate in spite of any provision in a contract or applicable law that modifies or terminates the property interest because of the debtor’s filing or insolvency.  Accordingly, the court found that the operating agreement’s language was ineffective to prevent the membership interest from becoming part of the estate, and the Arkansas statutory provision was “not enforceable because it is in conflict with federal law.”  It also found that under section 363(l) of the Bankruptcy Code (which contains similar anti-ipso facto language), Dixie was “permitted the use and benefit of its interest in the LLC and has the right to continue as a member of the LLC.”  The court therefore concluded that no event of disassociation had occurred as a result of the debtor’s bankruptcy filing.

While Dixie’s analysis of the issue is rather straightforward, other courts have considered the enforceability of similar statutory and contractual provisions through the more complicated lens of executory contracts, where the operation of ipso facto provisions in contracts is also restrained by the Bankruptcy Code.  In Dixie, the court made no findings on whether section 365 permitted or forbade the “disassociation” of the debtor’s membership interest because neither party submitted evidence as to whether the operating agreement was an executory contract, and the debtor’s plan asserted that the debtor had no executory contracts.  As a result, even if the operating agreement was executory, the debtor had not assumed it.

A number of additional issues arise in the executory contracts context, however.  First, are organizational documents executory contracts?  This is a complex question on its own, with holdings varying by court and sometimes contingent on the content of the organizational document.  Even where an organizational document is found or assumed to be an executory contract, complex questions arise as to the enforceability of ipso facto clauses in the agreement.  While section 365 of the Bankruptcy Code generally makes ipso facto clauses inoperable, an exception allows ipso facto clauses to operate where “applicable law” (beyond the terms of the contract itself) protects the non-debtor party from being required to accept performance from an assignee.  Moreover, some jurisdictions interpret section 365 as restraining assumption, or assumption coupled with assignment, where such “applicable law” excuses the non-debtor party from accepting performance by an assignee.

Each of these issues entails its own jurisdictional splits of interpretation, making the analysis of whether an ipso facto clause in an LLC agreement may operate against a debtor complicated; indeed, the issue prompted Vice Chancellor Strine, sitting in the Superior Court of Delaware, to remark, “I do not have all year to peer through the muck.”

Strine’s opinion illustrates one possible outcome of the analysis.  In considering whether a debtor’s LLC membership interests had terminated when it filed for bankruptcy he found that, because the Delaware LLC Act allows for assignment of “bare” economic, but not governance rights, contractual and statutory provisions that would terminate the debtor’s membership interest were pre-empted by the Bankruptcy Code to the extent that they terminated economic rights, but were preserved to the extent that they terminated governance rights.  As if to illustrate the type of variation that occurs under the 365 analysis, one court distinguished Strine’s opinion in Milford and allowed the trustee in bankruptcy to succeed to both economic and governance rights where a Delaware LLC had only a single member, and the policy behind Delaware law providing for dissolution of membership interests upon bankruptcy was not implicated.  Other courts applying different state law may come to yet other conclusions.

Strine briefly considered the application of section 541, but reviewed the contract under section 365 because the parties agreed that the LLC agreement in question was an executory contract.  Other cases have considered the two code sections side by side and proceeded to protect LLC interests under section 541, either in conjunction with protecting rights under 365, or after finding that the LLC agreement was not an executory contract.

This discussion only grazes the surface of the section 365 issues to illustrate the vexing questions that arise when membership cancellation provisions are considered under section 365, rather than section 541 of the Bankruptcy Code, which contains no equivalent exceptions to its ipso facto prohibition.  It is clear from even this basic outline, however, that the debtor is likely to have a much easier time preserving its LLC interests under section 541, and parties ought to consider the ipso facto clauses found there and in section 363(l) of the Bankruptcy Code, in addition to the more frequently chosen path down the rabbit holes of section 365.