Update to Asset Protection Proofing Your LP or LLC for a Bankrupt Partner or Member
Asset protection attorneys often advise a client who may have future creditor claims to transfer assets to a limited liability company (LLC) or limited partnership (LP) and to own an interest in the LLC as a member or in the LP as a limited partner.[1] They give this advice because Florida law limits a creditor’s rights against the interest of a debtor member or partner to a charging order, prohibits a creditor from foreclosing or owning the interest, and restricts the rights of a transferee of such interest.[2] However, Florida law does not apply to a bankrupt member’s or partner’s interest in an LLC or LP if the operating or limited partnership agreement is not an executory contract.[3] An executory contract must have material obligations that remain to be performed by both parties such that the failure to perform constitutes a material breach, excusing the performance of the other party.[4]
In 2007, The Florida Bar Journal published an article (prior article) that recommended incorporating provisions into an operating agreement or limited partnership agreement to cause the agreement to be treated as an executory contract.[5] This article reviews caselaw issued after the prior article and updates the types of provisions that attorneys should consider including in an operating or limited partnership agreement to ensure the agreement qualifies as an executory contract.
Executory Contracts
The Bankruptcy Code does not define the term “executory contract.” Caselaw defines an executory contract as an agreement under which performance remains due at least to some extent on both sides (i.e., by a debtor member and either non-debtor members or the LLC) at the time of the bankruptcy filing and, in particular, that requires a debtor member in possession to render significant performance before becoming entitled to obtain a significant counter-performance from the other party.[6] For example, a lease is an executory contract because a tenant must continue to timely pay rent to the landlord, obligating the landlord to continue to provide lease space to the tenant. If either obligation is breached, it affects the enforceability of the other party’s obligation. The key in determining whether an executory contract exists is that each party must have a future material obligation owed to the other party, which, if not performed, would excuse the obligation of the other party. If a member’s breach or default of the member’s duties and obligations does not necessarily excuse the performance of other members, the agreement will not qualify as an executory contract.
Operating and Partnership Agreements That Are Not Executory Contracts
The prior article focused on Movitz v. Fiesta Investments, LLC (In re Ehmann), 319 B.R. 200 (Bankr. D. Ariz. 2005). There, the court held that an operating agreement that had no material obligations to be performed by a debtor member was not an executory contract. As a result, the bankruptcy trustee could step into the shoes of the debtor and exercise the debtor’s right to dissolve the LLC to generate funds for the bankruptcy estate. In Ehmann, the debtor member was not a manager and did not perform any managerial duties for an LLC created for estate-planning purposes. The debtor member’s only obligation was not to voluntarily withdraw as a member. The bankruptcy court found that such an obligation was an option and not an affirmative duty.[7]
Since the Ehmann decision in 2005, bankruptcy courts have held that many other operating and limited partnership agreements did not constitute executory contracts. For example, in Rainsdon v. Duncan Ltd. P’ship (In re Duncan), LEXIS 493, No. 16-40205-JMM (Bankr. D. Idaho Feb. 24, 2023), a bankruptcy court held that a partnership agreement, which imposed no obligations on a debtor partner that failure to perform would constitute a material breach, was not an executory contract. The debtor partner only had an ongoing option to request a yearly distribution to pay his income taxes attributable to K-1 income assigned to the debtor from the partnership.[8] If the debtor partner wanted to transfer his interest, other partners had an obligation to consider granting written consent before any transferee would be treated as a substitute partner. If the court held that the partnership agreement was an executory contract and the bankruptcy trustee failed to assume or reject the agreement within the required time period, then the trustee would have been deemed to have rejected the debtor’s partnership interest.[9] Therefore, the trustee sought a determination that the agreement was not an executory contract so that the trustee could continue to own the partnership interest and cause the partnership to make a distribution to the trustee to pay income taxes. Other factors considered by the court in determining that the partnership agreement was not an executory contract were 1) a right of first refusal because it was an option;[10] 2) whether the partnership agreement was a personal service contract;[11] 3) the other rights granted to a limited partner that were not performance obligations (i.e., the right to a distribution upon withdrawal, the right to an accounting upon a partnership dissolution, the right to vote on amendments to the partnership agreement, and the right to access the partnership’s books and records); 4) the fiduciary duty of the partnership and its partners to act with good faith and fair dealing in all contractual relationships; and 5) whether estoppel and waiver applied against the trustee. In GenCanna Acquisition Corp. v. 101 Enters., LLC (In re Oggusa. Inc.), LEXIS 2158, No. 20-50133 (Bankr. E.D. Ky. Aug. 31, 2023), the court also did not consider transfer restrictions sufficient for an operating agreement to qualify as an executory contract. It held that the operating agreement did not constitute an executory contract when the only obligation was the consent requirement by the other members for a transfer of membership interest, because it was tantamount to an option and not an affirmative duty.
Several other courts have held that an operating or partnership agreement was not an executory contract for reasons similar to those described above. In particular, many courts looked for agreement provisions obligating the member to make additional capital contributions or giving the member managerial duties when making their determination. For example, in In re Yow, 590 B.R. 696 (Bankr. E.D. N.C. 2018), the court held that the operating agreement was not an executory contract where it only required the debtor member and another member to make initial de minimis capital contributions, did not obligate members to perform any managerial duties or do anything other than to attend the annual meeting, framed the members’ future responsibilities as speculative, and did not delineate or specify any required action or outstanding material obligations.[12]
Operating and Partnership Agreements That Are Executory Contracts
Since the prior article was published, many bankruptcy courts have held that an operating agreement or a limited partnership agreement is an executory contract. For example, Horizons A Far, LLC v. Webber (In re Soderstrom), 484 B.R. 874 (M.D. Fla. 2013), held that an operating agreement was an executory contract because a 50% debtor member was a managing member of the LLC required to provide managerial services and the bankruptcy trustee could not assume the debtor member’s managing member interest in the LLC without the prior consent of the other member. As another example, Pearce v. Woodfield (In re Woodfield), 602 B.R. 747, 758-759 (Bankr. D. Or. 2019), held that an operating agreement was an executory contract requiring the application of the agreement and Oregon’s LLC Act to an LLC owned equally by a debtor member and a non-debtor member because the agreement had the following provisions and ongoing obligations: requirement that members hold meetings or to otherwise authorize LLC actions, requirement that members manage the LLC’s business and affairs, requirement that members remain as members, requirement that members make additional capital contributions as required, and requirement that members obey restrictions on transfer of membership interests.
Other bankruptcy courts have found that an operating agreement or limited partnership agreement was an executory contract because partners or members were barred from competing.[13] For example, in In re Norquist, 43 B.R. 224 (Bankr. E.D. Wash. 1984), the court held that a limited partnership agreement that contained a covenant not to compete was an executory contract.[14] Similarly, in Hopkins v. Saratoga Holdings, LLC (In re Colvin), LEXIS 4339, 2007 WL 4553352, No. 04-42331-JDP (Bankr. D. Idaho Dec. 20, 2007), the court held that an operating agreement was an executory contract in part because of the debtor member’s covenant not to hinder, delay, slander, or tarnish the LLC.[15]
While some bankruptcy courts have also determined that a purchase obligation or an obligation to make a capital contribution in the partnership or operating agreement is sufficient to create an executory contract,[16] at least one other bankruptcy court has reached the opposite conclusion.[17] It is clear, however, that failing to include an ongoing obligation to make a capital contribution will likely cause the operating agreement to be a non-executory contract.[18]
Obligations That Should Be Included in Operating and Partnership Agreements
The prior article suggested that operating and partnership agreements should include the following obligations to assist in the determination that such agreement was an executory contract: 1) A statement that the agreement is an executory contract; 2) an obligation by each member or partner to make future capital contributions; 3) an obligation to comply with the member’s or partner’s fiduciary duties owed to the LLC and other members or to the LP and other partners; and 4) an obligation to manage the LLC by each member or to manage the LP by each partner.[19]
Based on bankruptcy decisions issued after the prior article, operating and partnership agreements should also emphasize a member’s duty not to compete under F.S. §605.04091(2)(c) and a partner’s duty not to compete under F.S. §620.8404(2)(c).[20] An operating agreement provision incorporating these obligations might look as follows:
Operating Agreement Constitutes an Executory Contract: The parties agree that this Agreement constitutes an executory contract and shall be governed by 11 U.S.C. §365 in connection with the bankruptcy of the Company or any Member because, among other provisions and obligations, this Agreement imposes on each Member the following affirmative duties (each of which constitutes a material unperformed, future obligation): (a) upon approval of Members owning a majority of outstanding membership units with voting power, the duty and obligation of each Member to contribute additional capital to the Company equal to [insert a material amount]; (b) the duty and obligation of each Member to materially participate in the management of the Company, including researching, reviewing and considering for approval all material actions and decisions taken or affirmatively not taken by the Company as well as any transfer of membership interest and admission of a new member to the Company [and list other specific managerial actions]; (c) the duty and obligation of each Member not to compete with the Company in the conduct of the Company’s activities and affairs before the dissolution of the Company in accordance with Section 605.04091(2)(c), Fla. Stats.; (d) the duty and obligation of each Member not to disclose confidential information of the Company; and (e) the duty and obligation of each Member not to hinder, delay, slander, or tarnish the Company. The failure of a Member to perform the duties and obligations set forth herein releases and excuses the mutual duties and obligations owed by the Company and the other Members to such defaulting Member. In accordance with In re Soderstrom, 484 B.R. 874 (M.D. Fla. 2013), the Agreement is a personal service agreement due to the managerial duties and obligations owed by each Member and a bankruptcy trustee cannot assume or assign a debtor Member’s interest in the Company in accordance with 11 U.S.C. §365(c)(1) without the prior written consent of the other Members. Notwithstanding the foregoing, to the extent that a trustee of a Member’s bankruptcy is allowed either to assume or reject a debtor Member’s interest in the Company governed by the Agreement, such action shall comply with the time period set forth in 11 U.S.C. §365(d), and if the trustee assumes such debtor Member’s interest, such trustee shall comply with the terms of this Agreement and Florida law governing this Agreement, including, without limitation, the restrictions of the rights of a creditor of a Member or transferee pursuant to Sections 605.0502 and 605.0503, Fla. Stats.[21]
Summary
If a client wants the terms of a partnership or operating agreement or Florida law to apply to a bankrupt debtor partner or member, then the attorney drafting the partnership or operating agreement should include provisions in the partnership or operating agreement requiring each partner or member to provide future material obligations to the LP, LLC, or other partners and members that, if not performed, would excuse the obligation of the LP, LLC, or such other partners and members to the bankrupt debtor partner or member.
[1] Thomas O. Wells, Asset Protection Provided with Florida Business Entities, Asset Protection in Florida 4-1 (8th ed. 2024).
[2] Fla. Stat. §§605.0401(3) (non-transferability), 605.0502(1) (limited rights of transferable interest), and 605.0503 (charging order remedy limitation) for a multi-member LLC; Fla. Stat. §§620.1702 (limited rights of transferable interest) and 620.1703 (charging order remedy limitation) for a LP.
[3] 11 U.S.C. §541(c)(1) provides that “an interest of the debtor in property becomes property of the estate…notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law that restricts or conditions transfer of such interest by the debtor.” Even if the operating or limited partnership agreement is an executory contract, an ipso facto contractual or legal provision that terminates or modifies the agreement, or any right or obligation of the debtor member or partner under the agreement, upon the bankruptcy, insolvency, or financial condition of the debtor member or partner may be unenforceable pursuant to 11 U.S.C. §365(e)(1). For example, Fla. Stat. §605.0602(8)(a) provides that a person who becomes dissociated as a member of a member-managed LLC if that person becomes a debtor in bankruptcy is an ipso facto provision and not enforceable. See In re Corky Foods Corp., 85 B.R. 903 (Bankr. S.D. Fla. 1988) (disregarding Florida partnership law dissolving a limited partnership upon the bankruptcy filing of a general partner under 11 U.S.C. §365(e)(1)); Summit Invest. and Dev. Corp. v. Leroux, 69 F.3d 608, 614 (1st Cir. 1995) (holding that 11 U.S.C. §365(e)(1) exempts the ipso facto provision included in the partnership agreement); but see In re Sunset Developers, 69 B.R. 710, 712-713 (Bankr. D. Idaho 1987) (holding that 11 U.S.C. §365(c) prevented 11 U.S.C. §365(e) from applying to a partnership agreement). However, all non-ipso facto contractual and legal provisions applicable to a member’s or partner’s interest in an LLC or LP will continue to apply if the operating agreement or limited partnership agreement is an executory contract. For further discussion, see Asset Protection in Florida §4.06.
[4] 11 U.S.C. §365(e)(1).
[5] Thomas O. Wells & Jordi Guso, Asset Protection Proofing Your Limited Partnership or LLC for the Bankruptcy of a Partner or Member, 81 Fla. B. J. 34 (Jan. 2007).
[6] In re Robert L. Helms Constr. & Dev. Co., 139 F.3d 702, 705 (9th Cir. 1998) (“A contract is executory if ‘the obligations of both parties are so unperformed that the failure of either party to complete performance would constitute a material breach and thus excuse the performance of the other.’”) (quoting Griffel v. Murphy (In re Wegner), 839 F.2d 533, 536 (9th Cir. 1988)).
[7] See also In re Price, 71 B.R. 341 (Bankr. N.D. Okla. 1987) (holding that an agreement providing debtor an option to pay money or forfeit an interest is not an affirmative bilateral obligation to perform creating an executory contract); Carruth v. Eutsler (In re Eutsler), 585 B.R. 231 (9th Cir. BAP 2017) (holding non-debtor partner’s right to purchase debtor partner’s equity upon a bankruptcy filing is an option and not an executory contract).
[8] In re Helms, 139 F.3d at 705, also held that a minimum income tax distribution is an option that does not create an affirmative mutual obligation constituting an executory contract.
[9] 11 U.S.C. §365(d)(1).
[10] See also In re Shroeder, LEXIS 3330, No. 3:21-bk-00707-LVV (Bankr. M.D. Fla. Dec. 1, 2021) (holding that a right of first refusal does not create an executory contract).
[11] In re Sunset Developers, 69 B.R. at 710, 713, held that a general partnership agreement consisting of two partners is a contract based on personal trust and confidence, which cannot be assigned or assumed without consent of the parties, causing it to be an executory contract as a personal service contract under 11 U.S.C. §365(c). The Duncan court rejected this argument and held that 11 U.S.C. §365(c) could not apply because it was dealing with a limited partner and because it had determined that the partnership agreement was not an executory contract. Rainsdon v. Duncan Ltd. P’ship (In re Duncan), LEXIS 493, No. 16-40205-JMM, at 16 (fn 6) (Bankr. D. Idaho Feb. 24, 2023).
[12] See also Hanckel v. Campbell, 2015 WL 7251714 (D. S.C. Mar. 10, 2015), 2015 U.S. Dist. LEXIS 154905 (D. S.C. March 10, 2015) (holding that operating agreement was not an executory contract because there was no obligation for members to contribute capital or provide management services to the LLC and the obligation to contribute capital required a unanimous vote of the members such that any member could prevent any capital call); In re Denman, 513 B.R. 720, 726 (Bankr. W.D. Tenn. 2014) (holding that operating agreement was not an executory contract where the members had no material obligations other than to make an initial capital contribution); In re Capital Acquisitions & Management Corp., 341 B.R. 632 (Bankr. N.D. Ill. 2006) (holding that operating agreement was not an executory agreement because there was no obligation by debtor to provide management services to LLC, and there was only a remote possibility that debtor might have certain future obligations, such as the obligation to indemnify the LLC from any loss incurred by virtue of assessment of tax with respect to debtor’s allocable share of the LLC’s profits or gain).
[13] The authors are not stating whether non-compete provisions are enforceable after the Federal Trade Commission’s non-compete rule, 16 C.F.R. §§910.1-910.6, became effective on Sept. 4, 2024.
[14] See also In re McSwain, LEXIS 3921, No. 07-43338 (Bankr. W.D. Wa. 2011) (holding that an operating agreement was an executory contract because of “multiple, mutual obligations” of the parties, including the debtor’s ongoing management duties and obligations to vote on major decisions and make additional capital contributions, where the debtor was subject to various restrictions on authorized transfers of the interest, and where the debtor was barred from competing against the company or disclosing confidential information).
[15] The court also held that the agreement was an executory contract based on the bilateral obligations of the non-debtor LLC to make payments to the debtor member based on his membership interest.
[16] Ebert v. Devries Family Farm, LLC (In re DeVries), 2014 WL 4294540, LEXIS 3621, No. 11-43165-DML-7 (Bankr. N.D. Tex. 2014) (holding that operating agreement is an executory contract where a debtor was obligated to make additional capital contributions and provide loan guarantees in highly volatile dairy industry); In re Newlin, 370 B.R. 870 (Bankr. M.D. Ga. 2007); Allentown Ambassadors, Inc. v. Northeast Am. Baseball, LLC (In re Allentown Ambassadors, Inc.), 361 B.R. 422 (Bankr. E.D. Pa. 2007) (holding that the duty to manage and the duty to make additional capital contributions if needed constituted ongoing, material unperformed obligations causing the operating agreement to be an executory contract); Calvin v. Siegal (In re Siegal), 190 B.R. 639 (Bankr. D. Ariz. 1996) (holding that an obligation to contribute capital to a partnership if needed combined with continuing fiduciary duty obligations between partners caused the agreement to be executory contract); In re Heafitz, 85 B.R. 274 (Bankr. S.D.N.Y. 1988).
[17] Samson v. Prokopf (In re Smith), 185 B.R. 285 (Bankr. S.D. Ill. 1995).
[18] See Hanckel, 2015 WL 7251714 at *6, LEXIS 154905 at *15; Yow, 590 B.R. at 701.
[19] The partnership agreement can vest and delegate management powers to a limited partner. Fla. Stat. §§620.1303 and 620.1305(1).
[20] Fla. Stat. §605.04091(2)(c) provides that the duty of loyalty owed by the managers of a manager-managed LLC and by the members of a member-managed LLC requires them to refrain from competing with the LLC in the conduct of the LLC’s activities and affairs before the dissolution of the LLC.
[21] A similar provision could be drafted for a partnership agreement. Lengthier sample provisions that may be included in an operating agreement or partnership agreement can be found in §4.8(C) of Asset Protection in Florida.
Thomas O. Wells, J.D. and LL.M. in taxation, practices tax, transactional, estate, and wealth preservation law in Coral Gables with the firm of Wells & Wells, P.A. He has an LL.M. in taxation from the Graduate Tax Program at the University of Florida Levin College of Law, is board certified by The Florida Bar in tax law, was named 1999 CPA of the Year in Business and Industry by the Florida Institute of Certified Public Accountants, and is a fellow in the American College of Trust and Estate Counsel. Wells is also the author of “Chapter 4 — Asset Protection Provided with Florida Business Entities” published by The Florida Bar in Asset Protection in Florida.
Cassandra (Cassie) S. Nelson is a shareholder at Nelson & Nelson, P.A., in North Miami Beach. She practices in estate planning, asset protection, tax, special needs trusts, guardianships, and probate administration. Nelson co-authored the homestead creditor issues chapter in Asset Protection in Florida (8th ed.) published by The Florida Bar. She earned a B.A. from the University of Miami, magna cum laude (2013), and J.D. from Emory University School of Law (2017). Nelson is currently pursuing an Executive LLM in taxation at New York University.
This column is submitted on behalf of the Real Property, Probate and Trust Law Section, John C. Moran, chair, and Allison Archbold and Homer Duvall, editors.
