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).
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Nelson Mullins Riley & Scarborough LLP by Jody Bedenbaugh. Published October 6, 2021.