Contributed by Jessica Diab
Several state statutes governing alternative entities, such as limited liability companies, have a provision that divests a member of its non-economic interest in an LLC (e.g., management rights or the right to vote) upon filing for bankruptcy. Generally, the divesting provision treats the debtor member as an assignee, and as such, the debtor member is permitted to retain an economic interest in the LLC, but is not entitled to exercise any of its non-economic rights. These statutory provisions embody a policy view that, absent a contractual provision to the contrary, members of an LLC need not fear that they will have, as fellow voting members, debtors whose economic incentives may be distorted and detrimental to the LLC. In 2004, Chancellor Strine (then Vice Chancellor Strine) of the Delaware Court of Chancery considered whether, upon filing for bankruptcy, a debtor retained its membership interest in an LLC and whether statutory provisions divesting a debtor of its non-economic membership interest in an LLC were preempted by the Bankruptcy Code. In rendering his opinion, Strine acknowledged that the answers to these questions were not clear, but he did not have time to “peer through the muck in search of what will at most be a debatable answer.”
In 2011, we started to peer through this “muck,” recognizing that the treatment of a debtor’s interest in an LLC depends fundamentally on whether the membership agreement governing the debtor’s interests is treated as property of the estate or as an executory contract. When a court treats a membership agreement as property of the estate, any provision in the state’s LLC Act divesting the debtor of its non-economic rights in the LLC solely because of the bankruptcy filing (commonly referred to as an “ipso facto” provision) is preempted by section 541(c)(1) of the Bankruptcy Code, which preempts any applicable nonbankruptcy law divesting a debtor of its interest in property solely because of the debtor’s insolvency or financial condition. By contrast, when a court treats a membership agreement as an executory contract, it is less clear whether such an ipso facto provision is preempted by the Bankruptcy Code because section 365(c)(1)(A) preserves the enforceability of certain ipso facto provisions in executory contracts. Under this section, a debtor may not assume or assign an executory contract where applicable law (e.g., a state’s LLC Act) would not require the nondebtor party to accept performance from an assignee. This provision reflects Congress’s acknowledgement that certain types of executory contracts to which debtors are parties should not be assignable or assumable by the debtor in circumstances where state law would not require the nondebtor parties to accept substitute performance. As Chancellor Strine discussed, under section 365(c)(1)(A), a state statute excusing nondebtor members of an LLC from accepting performance of non-economic rights from an assignee would prevent the debtor, who is often treated as an assignee under state statutes governing LLCs, from assigning (and, in some jurisdictions, depending on whether the ‘hypothetical’ or the ‘actual’ test governs, assuming as well) its non-economic interest in an LLC.
Unfortunately, today’s post cannot clear the “muck.” Instead, we continue the discussion on the issue by addressing a recent decision from the United States Bankruptcy Court for the Western District of Virginia where the court held that a debtor’s membership interest in an LLC was property of the estate and that any state law provision divesting the debtor of its non-economic interest in the LLC (e.g., a right to vote) was preempted by section 541(c)(1) of the Bankruptcy Code.
In In re Virginia Broadband, LLC, the official committee of unsecured creditors filed a motion to dismiss Virginia Broadband’s chapter 11 case, alleging that a majority of Virginia Broadband’s board did not authorize the filing of the chapter 11 petition. In particular, the committee argued that the petition was defective because Chapman, one of the largest equity holders on the Board of Managers, had lost all his non-economic rights in Virginia Broadband upon his personal bankruptcy filing and therefore, his vote in favor of the petition, despite occurring after dismissal of his chapter 13 case, had no effect. The committee’s argument relied primarily on a provision in Virginia’s LLC Act, which provides that, upon a member filing for bankruptcy, the member is treated as an assignee and is entitled to receive the share of profits and losses, but is not entitled to participate in the management and affairs of the LLC. Accordingly, from a strictly state law perspective, Chapman’s right to vote was divested by his bankruptcy filing and consequently, Virginia Broadband’s chapter 11 petition was not properly authorized.
The court went on to consider, however, whether any provisions of the Bankruptcy Code would preempt this outcome. Section 349 of the Bankruptcy Code provides that, upon dismissal of a bankruptcy filing, property of the estate, which was held by the debtor prior to the case, revests in the debtor. Accordingly, if Chapman’s non-economic interest was property of the estate, it would have revested to Chapman upon the dismissal of his bankruptcy case, and Chapman would have been entitled to vote in favor of Virginia Broadband’s petition. The court did not thoroughly tackle the question of whether the membership agreement should be treated as a property interest or an executory contract, but instead concluded that because Virginia’s LLC Act states that a membership interest, including both economic and non-economic rights in an LLC, is personal property, the debtor’s membership interest in the LLC was property of the estate. The only issue remaining for the court was whether, once Chapman filed his bankruptcy petition, Chapman was stripped of his non-economic rights pursuant to Virginia’s LLC Act. Having concluded that the membership interest was property of the estate, the court held that any provision in Virginia’s LLC Act divesting the debtor of its non-economic rights in the LLC was an ipso facto provision that was clearly unenforceable under section 541(c)(1) and therefore, both the economic and non-economic interest in the LLC were property of the estate. Accordingly, the court denied the committee’s motion to dismiss the petition finding that Chapman’s vote in favor of the chapter 11 petition was valid.
It is far from clear when an LLC membership agreement will be treated as property of the estate or as an executory contract and, equally, when a member’s economic and non-economic interests will be treated as the debtor’s property or as a contractual right. It is worth considering, however, the great potential for diverging outcomes as a result of an inconsistent treatment of such agreements. Had the court in Virginia Broadband concluded that Chapman’s membership interest in the LLC was a contractual right because the membership agreement governing Chapman’s interests was an executory contract, as Chancellor Strine had concluded years earlier, a more complex analysis would have necessarily ensued, and the court might have concluded that the petition was unauthorized because the divesting provisions in Virginia’s LLC Act constituted “applicable law” which did not require a nondebtor party to accept substitute performance. In other words, section 365(c)(1) might have preserved the application of the ipso facto provision that divested Chapman of his right to vote.
In sum, parties litigating the LLC issue must still wade through the muck; however, there appears to be a whole lot less of it where courts treat membership agreements as property of the estate, as oppose to as executory contracts.