An operating agreement is a legal binding contract used by LLCs because it outlines the business’ financial and functional decisions including rules, regulations and provisions. The essence of this legal document is to govern the internal operations of the business in a way that suits the specific needs of the business owners. Once the document is signed by the members of the limited liability company, it acts as an official contract binding them to its terms.

However, an LLC Operating Agreement being an executory contract will depend on the materiality of non – performance of remaining obligations. Since there is no blanket rule applicable to LLC operating agreements, it will require an analysis of the operating agreement as a whole, the applicable limited liability company act, and other applicable state law to determine if it is an Executory Contract.

Just like with any other agreement, determining whether an operating agreement is in a particular case an ‘executory contract’ is a question of fact for the Bankruptcy Court. Notably, the Bankruptcy Code does not explicitly define “executory contract.”

Over the years, most have adopted the “Countryman Test,” which provides that a contract is executory if ‘the obligations of both parties are so far unperformed that the failure of either party to complete performance would constitute a material breach and thus excuse the performance of the other.’

Have it in mind that when a debtor files bankruptcy, a bankruptcy “estate” is established pursuant to Section 541 of the Bankruptcy Code. This particular debtor’s bankruptcy estate includes “all legal or equitable interests of the debtor in property as of the commencement of the case.”

Notably, Section 541 clarifies that an interest of the debtor becomes property of the bankruptcy estate irrespective of any provision in any agreement or applicable no bankruptcy law that restricts or conditions transfer of such interest by the debtor.

Thereby, the debtor’s bankruptcy estate (and by extension the trustee, whose responsibility it is to administer the property of the estate for the benefit of the debtor’s creditors) generally automatically succeeds to all of the debtor’s property interests free and clear of any state law or contractual restrictions or conditions.

However, since an executory contract is considered both a potential asset and a potential liability of the debtor, it is treated differently. In the United States, Section 365 of the Bankruptcy Code caters to executory contracts.

How to Protect Your LLC from the Bankruptcy of an LLC Member

Have it in mind that the bankruptcy of an LLC member aside from disrupting business operations also results in costly litigation. However, you can bullet proof your LLC by including provisions in your LLC’s operating agreement that prevent future chaos. Here are 4 four key provisions that you and your attorney should include in the operating agreement to protect it in an LLC member’s bankruptcy proceeding:

  1. Make Sure That Your Operating Agreement Is an “Executory Contract” Under § 365

According to experts, ensuring that your LLC’s operating agreement is an “executory contract” in bankruptcy is without doubts the most important part of bullet proofing your LLC from the bankruptcy of an LLC member. Just like it was expressed above, an “executory contract” is a contract where both parties still need to perform under the contract and the “obligation of both the [debtor] and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.”

It further entails that the debtor LLC member is expected to have substantial, current, unperformed obligations if an operating agreement is to be treated as an executory contract.  If this is the case, the non – debtor LLC members are excused from “accepting performance” from a third party, such as a bankruptcy trustee, allowing the trustee to have an economic interest in the company, but no management or voting rights.

Note that this is imperative since an LLC interest with no voting rights is less appealing to a bankruptcy trustee trying to maximize profits for the bankruptcy estate as it prevents the trustee from selling the LLC.

Howbeit, the ideal way to phrase this provision in the operating agreement is to state that the “members’ intent is that the operating agreement be deemed an executory contract.”  Also, courts have found that the following obligations are “material” for purposes of considering whether a breach of this obligation by one member would excuse the performance of the other, non – breaching members:

  • Obligation to make cash contribution or respond to capital calls (without veto right by member)
  • Obligation to provide personal services
  • Restriction from engaging in unauthorized transfer of membership interest
  • Non – compete and/or non – disclosure obligations
  • Affirmative restriction from voluntarily withdrawing as member
  • Guarantee of LLC’s debt

Have it in mind that including any of these provisions in your operating agreement as member obligations is pertinent for purposes of establishing the operating agreement as an executory contract.

  1. Add a Right of First Refusal or Other Option to Purchase the Estate’s Interest Upon a Proposed Sale

The second provision that you should consider including in your operating agreement to ensure it is protected if an LLC member files for bankruptcy is a provision detailing the right of first refusal or other option to purchase in the event of a sale or transfer, including a sale in bankruptcy.

Note that including the right of first refusal in your operating agreement also makes it more likely that your operating agreement will be treated like an executory contract, allowing it to be rejected by the non – bankrupt LLC members.

This means that the right of first refusal is a very important tool for non – debtor members to maintain control of the LLC, irrespective of whether the operating agreement is executory.  However, as long as you and your attorney do not tie the right of first refusal to the bankruptcy filing; the LLC member debtor’s financial condition; or the appointment of a trustee, the court is likely to uphold the right of first refusal.

  1. Make Sure the Operating Agreement and Any Other Formation Documents are “Integrated”

The third provision to consider including in your operating agreement is a provision that ensures that the operating agreement and any other LLC formation documents, like capital call agreements, options or personal service agreements, are “integrated”.

Note that when dealing with a bankruptcy, integrated documents are beneficial because they ensure that if a member files bankruptcy, the bankruptcy trustee cannot cherry pick the favourable contracts of the LLC and reject the less favourable ones, which makes it less likely that the trustee will assume any of the LLC’s contracts.

  1. Include in Your Operating Agreement That a Material Breach of the Operating Agreement Makes a Member a Mere Assignee Without Voting Rights

The last provision for your LLC should be explicitly tailored to provide a potential alternative to you and your LLC for preventing a Chapter 7 trustee from obtaining non – economic rights such as management or voting rights. Note that the following revision might prevent a bankruptcy trustee from obtaining non – economic rights:

“A member shall cease to be a member of the Company and that member shall attain the status of mere assignee under Section __ of this Operating Agreement upon the occurrence of one or more of the following events: … (A) Material breach of this Operating Agreement…”

Ideally, this provision can be very helpful since an ultimate rejection of an LLC contract under this provision does not terminate the contract itself but rather frees the estate from any obligations under the contract, and the operating agreement would still govern the Chapter 7 trustee’s rights under it, if any.

Conclusion

The operating agreement is similar to a corporation’s bylaws. Every LLC has a unique operating agreement that states the understanding between the members regarding ownership interests and details of operating the business. In a multi – member entity, the operating agreement becomes a binding contract on all members. Howbeit, putting together an operating agreement should warrant extensive discussions and negotiations between members to work out the various elements of the agreement.

Solomon. O'Chucks