The Exciting (or Bewildering?) Intersection of Bankruptcy Code Section 365 and the Sale of LLC Membership Interests
Debtors and trustees are faced with the task of maximizing the value of bankruptcy estate assets in the face of many obstacles, such as limited liquidity runway and the competing interests of various creditor and equity constituencies. One estate asset that may raise particular challenges for maximizing value is the sale of debtor’s membership interest in a limited liability company (LLC) when it is subject to restrictions on assignment under the LLC’s operating agreement and underling state law. For example, the LLC operating agreement may give the other LLC members the right to approve the admission of a new member transferee or provide them the right of first refusal in connection with any purported sale of a membership interest. Likewise, state LLC statutes typically contain similar restrictions. For example, the North Carolina Limited Liability Company Act contains restrictions on the transfer of membership interests. See N.C. Gen. Stat. Ann. § 57D-3-03 (“The approval of all members is required to . . . [a]dmit any person as a member”); N.C. Gen. Stat. Ann. § 57D-5-04 (economic interest holder may become a member only if provided in the operating agreement or by approval of other members); N.C. Gen. Stat. Ann. § 57D-5-02 (“The transfer of an economic interest or portion thereof does not entitle the transferee to become or exercise any rights of a member other than to receive the economic interest or the portion thereof assigned to the transferee”).
One potential avenue through this web of restrictions is Bankruptcy Code Section 365. The applicability of Section 365 turns on whether the LLC operating agreement is considered an “executory contract.” There is no blanket rule as to whether LLC operating agreements are executory. Courts must examine each operating agreement on a case-by-case basis. Where the LLC members have material, unperformed obligations under the agreement, courts routinely hold that the operating agreements are executory. See, e.g., In re Allentown Ambassadors, Inc., 361 B.R. 422, 444 (Bankr. E.D. Pa. 2007) (LLC operating agreement was executory because members had ongoing, material, unperformed obligations to one another and the LLC as of the commencement of this bankruptcy case, which included (i) the duty to manage the LLC and (ii) the duty to make additional cash contributions if needed by the LLC); Matter of Daugherty Const., Inc., 188 B.R. 607, 612 (Bankr.D.Neb.1995) (concluding that an LLC agreement is an executory contract); In re DeLuca, 194 B.R. 65, 77 (Bankr.E.D.Va.1996) (concluding that an LLC agreement is an executory contract where parties had ongoing duties and responsibilities); In re Sunset Developers, 69 B.R. 710, 712 (Bankr.D.Idaho 1987) (holding that a partnership agreement imposing ongoing mutual obligations is an executory agreement).
If the debtor or trustee is successful in convincing the bankruptcy court that the operating agreement is executory, the debtor/trustee may argue that Section 365(f)(1) allows the debtor/trustee to assume and assign the operating agreement to a third party buyer, notwithstanding the restrictions in the operating agreement and applicable law. Section 365(f)(1) provides that, “notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease.” 11 U.S.C. § 365(f)(1). See also In re Trak Auto Corp., 367 F.3d 237, 241 (4th Cir. 2004) (recognizing that Section 365(f)(1) “generally allows a debtor to assign its lease [or executory contract] notwithstanding a provision restricting assignment”); 6711 Glen Burnie Retail, LLC v. Toys "R" Us, Inc., 2018 WL 6787942, at *2 (E.D. Va. Dec. 26, 2018) (Section 365(f)(1) “prohibits the enforcement in bankruptcy of anti-assignment clauses” contained in executory contracts and unexpired leases)(internal quotations omitted); In Re Bulldog Trucking, Inc., 1994 WL 835073, at *17 (Bankr. W.D.N.C. Feb. 18, 1994) (“Section 365(f)(1) . . . generally makes unenforceable a provision in applicable law that prohibits, restricts, or conditions the assignment of an executory contract or unexpired lease”) (internal quotations omitted); In re E-Z Serve Convenience Stores, Inc., 289 B.R. 45, 49 (Bankr. M.D. N.C. 2003) (“[w]hile a trustee is required to assume a contract as a whole, the court may strike provisions that are contrary to the provisions of the Bankruptcy Code such as those that place restrictions on assignment”).
The debtor/trustee’s opponent, however, is certain to argue that what Section 365(f)(1) giveth, Section 365(c)(1)(A) taketh away. Section 365(c)(1)(A) appears to conflict with Section 365(f)(1), stating follows:
The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if—
(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(B) such party does not consent to such assumption or assignment.
The apparent inconsistency between Sections 365(f)(1) and 365(c) has been discussed and analyzed numerous times in various jurisdictions. See, e.g., In re Buildnet, Inc., 2002 WL 31103235, at *4 (Bankr. M.D.N.C. Sept. 20, 2002) (the “applicable law in 365(c) means non-bankruptcy law that excuses the non-debtor from accepting performance from or rendering performance to anyone other than the debtor”)(internal citations and quotations omitted). Also, in In re Allentown Ambassadors, Inc., 361 B.R. 422, 444 (Bankr. E.D. Pa. 2007), the court noted “that Section 365(c) and (f) are difficult provisions to understand, harmonize and apply” and that “[t]here may now be as many as seven (7) lines of cases addressing the meaning of and interrelationship between § 365(c) and (f).” Id. at 446-47. The Allentown court also summarized the law construing Sections 365(c) and 365(f) as follows:
Most courts, however, have resolved the apparent conflict between sections 365(c)(1) and 365(f) by ascribing a different meaning to the phrase “applicable law” appearing in each section. For example, the United States Court of Appeals for the First Circuit has interpreted the phrase “applicable law” in section 365(f) as applying only to state laws that enforce contract provisions that prohibit, restrict or condition assignment, and the phrase “applicable law” in section 365(c)(1) as applying to state laws that, on their own terms, prohibit, restrict or condition assignment of a particular type of contract.
Other courts have ... attempted a similar method of resolving the apparent conflict between sections 365(c)(1) and 365(f)(1) of the Bankruptcy Code. For example, the United States Courts of Appeal for the Fourth, Sixth, Ninth and Eleventh Circuits have interpreted the phrase “applicable law” in section 365(f)(1) as applying to general prohibitions against assignment, and the phrase “applicable law” in section 365(c)(1) as applying to specific laws that excuse a contracting party from rendering performance to, or accepting performance from, a third party. Under this construction, section 365(c)(1) applies when the identity of the original contracting party is material.
Id. at 447 (internal citations omitted). See also In re ANC Rental Corp., Inc., 277 B.R. 226, 235 (Bankr. D. Del. 2002) (describing the apparent conflict between Sections 365(c) and (f) as arising from “their respective treatments of ‘applicable law,’ as each subsection recognizes an ‘applicable law’ of markedly different scope”)(internal quotations and citations omitted). As described in ANC Rental Corp., “a majority of courts have found section 365(c)(1) applicable only where the identity of the contracting party is crucial under the applicable law.” ANC Rental Corp., 277 B.R. at 235 (collecting cases applying majority rule). The Fourth Circuit adopted this view in 2004. See Sunterra Corp., 361 F.3d at 266. There, the court reasoned that “under the broad rule of § 365(f)(1), the ‘applicable law’ is the law prohibiting or restricting assignments as such; whereas the ‘applicable law’ under § 365(c)(1) embraces legal excuses for refusing to render or accept performance, regardless of the contract's status as assignable.”) Id. (internal quotations and citation omitted). The court also reasoned that “Section 365(c)(1) . . . creates a carefully crafted exception to the broad rule, under which applicable law does not merely recite a general ban on assignment, but instead more specifically excuses a party . . . from accepting performance from or rendering performance to an entity different from the one with which the party originally contracted.” Id. Therefore, based on this reasoning, the court held that only “applicable anti-assignment law predicated on the rationale that the identity of the contracting party is material to the agreement is resuscitated by § 365(c)(1).” Id. at 266-67 (also holding,“[p]remised on this interpretation, we agree with those Circuits that apply § 365(c)(1) literally—the provisions of § 365(c)(1) are not inevitably set at odds with the provisions of § 365(f)(1)”).
While the case law addressing the reconciliation between Sections 365(c) and (f)(1) in the context of a transfer of an LLC interest appears to be limited, at least one Court has addressed the issue. In Allentown, the court — applying the majority view to a prior version of the North Carolina LLC Act – held that the prior LLC Act did not contain a clear, unambiguous prohibition against assignment without the consent of the other parties to the contract, and therefore the non-debtor parties were not excused from accepting performance from a party other than the debtor. See Allentown, 361 B.R. at 455 (courts must “consider whether the nature of the operations of [the LLC] are such that a change in the identity of an assignee would be a material impairment of the rights of other members” to determine whether limited Section 365(c) exception applies). In so holding, the Allentown court demonstrates a narrow pathway through the bewildering maze of state LLC law and Section 365 — and provides hope to debtors and trustees seeking to sell an LLC membership interest for the benefit of the bankruptcy estate and its creditors.
 Most courts utilize the “Countryman Test” determine whether a contract is “executory.” See In re Sunterra Corp., 361 F.3d 257, 264 (4th Cir. 2004) (citing Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir.1985)). Under the Countryman Test, a contract is executory if the “obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete the performance would constitute a material breach excusing the performance of the other.” Id. (internal quotations omitted). The court in Sunterra explained that a contract meets the Countryman definition where each party owes “at least one continuing material duty to the other under the Agreement,” such as an “an ongoing obligation to maintain the confidentiality” of the content of the agreement. Id.