In re Soderstrom Case Analysis

In In re Soderstrom, 484 B.R. 874 (M.D. Fla. 2013), the district court held on appeal that Roger and Tansey Soderstrom’s bankruptcy trustee could sell their half of a Florida LLC as an economic interest only. The other member had not consented to a new managing member, and the Bankruptcy Code barred the trustee from assuming the agreement without that consent.

The court applied the functional test for an executory contract that the Eleventh Circuit had accepted, which asks whether assuming the contract would benefit the estate. Whether an operating agreement is executory decides which section of the Bankruptcy Code governs the trustee, and the answer differs from the one an Arizona bankruptcy court reached in In re Ehmann.

How the Trustee Came to Sell Half of an LLC

Roger and Tansey Soderstrom owned 50 percent of Plaza N 15 Partners, LLC, a Florida limited liability company. Scott Buono owned the other 50 percent. When the Soderstroms filed bankruptcy, their half of the company became property of the bankruptcy estate, and Richard Webber was the trustee.

Horizons A Far, LLC, a creditor of the estate, offered to buy the Soderstroms’ 50 percent interest along with other estate property. The trustee accepted and filed a notice of intent to sell. Buono objected. He argued that without his consent as the other managing member, the operating agreement allowed a sale of only the Soderstroms’ economic interest, and no part of their right to manage the company.

The bankruptcy court agreed and approved a sale of the 50 percent economic interest alone. It gave two reasons. Whatever interest the trustee acquired in the company was subject to the consent restrictions in the operating agreement. And under section 365 of the Bankruptcy Code the trustee had never acquired the management interest at all, because the operating agreement was an executory contract that Buono had not consented to let the trustee assume.

Horizons then objected to the sale order, but on a new theory. As a creditor, it argued, it could compel the trustee to sell 100 percent of the company, Buono’s half included, under the Bankruptcy Code section that lets a trustee sell a co-owner’s share of property. The bankruptcy court overruled the objection on five grounds, among them that the argument came more than twenty-one days after the notice of sale and that the company was neither a tenancy in common nor a joint tenancy.

Horizons appealed both orders to the district court, which stayed the sale while the appeals were pending. Judge Roy B. Dalton, Jr. heard oral argument and affirmed both orders on January 7, 2013.

Why the Operating Agreement Was Executory

An LLC operating agreement is executory in the Eleventh Circuit if assuming or rejecting it would benefit the bankruptcy estate and its creditors, even when only one side still owes a material obligation. Whether a contract is executory is a question of federal law, so the district court decided it fresh. Horizons argued that the bankruptcy court had used the wrong test, the traditional one that asks whether both parties still owe material performance.

The district court did not have to decide whether the bankruptcy court had used the wrong test, because the agreement was executory under either. The Eleventh Circuit had tacitly approved the functional approach in Thompkins v. Lil’ Joe Records, Inc., 476 F.3d 1294 (11th Cir. 2007). Under that approach a contract can be executory even though only one party still has outstanding obligations, if assuming or rejecting it would benefit the estate.

Horizons’ own argument supplied the answer. Its whole appeal rested on the claim that selling the full economic-and-management interest would net more for the estate, and for Horizons as a creditor, than selling the economic interest alone. That benefit is the functional test’s definition of an executory contract, so the court found the agreement executory and treated any error in the bankruptcy court’s choice of test as harmless.

Once the agreement was executory, section 365 governed the trustee’s rights instead of section 541(c)(1), the provision that puts a debtor’s property into the estate despite restrictions on transfer. Section 365(c)(1) bars a trustee from assuming an executory contract when applicable law excuses the other party from accepting performance from anyone but the debtor, unless that party consents. Buono, the other managing member, did not consent, so the trustee never took the Soderstroms’ management interest and could sell only their economic interest.

Why the Whole LLC Could Not Be Sold

A bankruptcy trustee cannot sell a non-debtor member’s LLC interest under section 363(h) of the Bankruptcy Code, which reaches only property the debtor held as a tenant in common, joint tenant, or tenant by the entirety. The Eleventh Circuit had held in In re Livingston, 804 F.2d 1219 (11th Cir. 1986), that the section is construed narrowly and applies only to those listed forms of ownership.

Horizons argued that the Soderstroms and Buono co-owned the company, that partition was impracticable in a closely held business, and that a sale of the whole company would bring in far more than a sale of half.

The district court answered that a member’s interest in an LLC is wholly different from an undivided interest in property held by co-owners. Each member’s share of the LLC is his own personal property, and that share, the Soderstroms’ membership interest, was the relevant property. Owning equal halves of the company did not make the Soderstroms and Buono co-owners of the Soderstroms’ interest.

The operating agreement’s buy-sell provision did not help Horizons either. That provision let one member force the other to sell in certain situations, but it applied only to sales between members. Horizons was not a member and had no standing to invoke it, and the same consent restrictions that kept the trustee from taking management rights barred a forced sale of a member’s management interest to an outsider.

The court also rejected the argument that the trustee had abused his discretion by refusing to pursue the larger sale. The trustee had told the bankruptcy court he would sell 100 percent of the company only if the court found he was permitted to, and he wanted to maximize the estate’s recovery only in ways the law allowed. Declining to advance a legally unsound sale was a sound exercise of a trustee’s business judgment.

Horizons’ due process argument failed with the rest. The sale order itself gave Horizons notice that only the economic interest would be sold, and Horizons could have objected. Instead it proposed a new sale three months after the objection deadline had passed. The bankruptcy court properly treated that objection as a motion for reconsideration, and it considered the merits anyway.

What a Trustee Takes From a Multi-Member LLC

When a member of a multi-member Florida LLC files bankruptcy, the trustee takes the member’s interest, and what the trustee can do with it turns on whether the operating agreement is an executory contract. If the agreement is executory, section 365(c)(1) lets a non-consenting co-member keep the trustee out of management, and anyone who buys the interest from the trustee. The trustee is left with the right to distributions, which is what Soderstrom allowed the trustee to sell.

If the agreement is not executory, the analysis runs through section 541(c)(1), and courts have split on what follows. In In re Ehmann, 319 B.R. 200 (Bankr. D. Ariz. 2005), an Arizona bankruptcy court held there was no executory contract where the agreement placed no obligation on a non-managing member. Section 541(c)(1) then made the transfer restrictions unenforceable against the trustee, whether they came from the agreement or from Arizona’s statute, and the estate took the member’s rights whole.

In In re Garrison-Ashburn, L.C., 253 B.R. 700 (Bankr. E.D. Va. 2000), a Virginia bankruptcy court also held there was no executory contract. The agreement set out how the company would be managed and imposed no duty on a member to contribute capital, to manage, or to provide services. It held that Virginia’s statute dissociated the member on filing, leaving the estate with an assignee’s economic rights. Whether an operating agreement imposes real obligations on the member is the fact that separates the two lines.

An earlier Virginia decision, Broyhill v. DeLuca (In re DeLuca), 194 B.R. 65 (Bankr. E.D. Va. 1996), reached the executory-contract result by a different route. The court held that the operating agreement of a development company was executory because the members still owed duties to bring the project to completion, and that it was a personal-services contract because the managers’ identities were material to the venture. Soderstrom required no such showing. The functional test made the agreement executory because assuming the management interest would have benefited the estate.

The single-member LLC is the contrast. In In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003), the trustee of a sole member took the entire interest, management rights included, because there was no other member to withhold consent. In Soderstrom there was one, and his refusal held the trustee to the economic interest.

Florida’s LLC statute, rewritten after Soderstrom was decided, points the same way. After a company is formed, a person becomes a member as the operating agreement provides or with the consent of all the members, and a transferee of a member’s interest receives only the distributions the member would have received.

Outside bankruptcy, a multi-member LLC member’s judgment creditor gets a charging order against distributions and cannot foreclose on the interest. A sole member’s creditor can foreclose once a charging order will not pay the judgment within a reasonable time. Among the Florida charging order and LLC decisions, Soderstrom is the one that applies the bankruptcy side of that line to a two-member Florida company.

What Soderstrom Means for an Operating Agreement

A Florida operating agreement that requires the other members’ consent before a transferee may manage the company gives a non-debtor member a defense a bankruptcy trustee cannot override, provided the agreement is an executory contract. The consent restriction is the term that did the work in Soderstrom. The bankruptcy court found that applicable law let the members withhold consent to a new managing member, and Buono withheld it.

The executory-contract question is where a trustee will press. A trustee who argues that the management interest adds value to the estate is describing a benefit from assumption, and that benefit is the functional test’s own definition. Horizons argued itself into that position. An agreement that gives members real continuing obligations, such as duties to manage or to contribute capital when called, is executory under the traditional test as well. The court in DeLuca found one executory on that ground.

The decision has limits. It is a district court ruling on appeal from a bankruptcy court, decided under the LLC statute Florida replaced in 2014, and it binds no other court. It concerned a two-member company in which both members managed, and the court never reached what a trustee takes when the agreement is not executory. On that question Ehmann and Garrison-Ashburn still point in opposite directions.

For the owner of a multi-member LLC, the practical protection is a genuine co-member who can refuse consent and an agreement that conditions management rights on that consent. That is also what keeps a charging order the exclusive remedy outside bankruptcy. Among the Florida asset protection cases, Soderstrom shows the same structure holding when the creditor is a bankruptcy trustee instead of a judgment creditor.