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First-Refusal Right Was Executory Contract

In this corporate debtor’s bankruptcy, a right of first refusal in a limited liability company’s operating agreement is an executory contract that either expired by its own terms or was rejected by the bankruptcy trustee, and the Alexandria U.S. District Court grants the Chapter 7 trustee’s motion to sell a membership interest and promissory note over the company’s objection.

The bankruptcy estate owns 16.33 percent of the membership interest of I3 Group (‘company’) and a $600,00 note payable to the debtor from I3 Group. Partnership Liquidity Investors (‘prospective bidder’) expressed an interest in purchasing the membership interest and the note. In order to obtain the best price for the estate’s assets, the trustee proposed to sell the assets as a single lot at a public auction. The company objected because its operating agreement provides for a right of first refusal, first to the company and then, if not exercised by the company, to the members. It asserts that at the conclusion of an auction, it has the right, if it elects to do so, to purchase the membership interest at the highest bid. The parties agree the operating agreement contains a right of first refusal, but disagree on whether it is an executory or non-executory contract.

There is no per se rule that characterizes all LLC operating agreement as either executory or non-executory. Each is individually analyzed. The 4th Circuit says a contract under which the obligation of both the bankruptcy 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 performance of the other.

The company argues that a naked right of first refusal is not an executory contract. A naked right of first refusal is a right on the part of the non-selling member to purchase the selling member’s interest where the right of first refusal automatically expires upon the failure to affirmatively exercise the right of first refusal within a reasonable period of time and the non-selling member, upon exercising the right of first refusal, has no obligation other than to pay the purchase price. Such a right of first refusal is not an executory contract. The failure of the non-selling member to exercise his right of first refusal does not constitute a breach, much less a material breach excusing performance by the selling member. The non-selling member is simply under no obligation to exercise the right of first refusal. Nor does it become an executory contract upon exercise of the right of first refusal because the only performance required of the non-selling member is the payment of money.

That is not the case here. The company and the members if the company does not exercise its right of first refusal, have unperformed obligations. The failure of the company to give the required notice in conformity to the agreement is a material breach. The 30-day period for the exercise of the right of first refusal commences on receipt of the notice. Failure to timely give the notice prejudices the selling member because he cannot proceed with the transaction without the other members exercising their right of first refusal or allowing the right to expire.

When the right of first refusal transaction is viewed as a whole – with numerous individual obligations that are part and parcel of the right of first refusal transaction – it is itself an executor contract.

Here, the right of first refusal has been rejected. The trustee properly notes that 11 U.S.C. § 365(d)(1) provides a 60-day period for the trustee to assume or reject a contract for personal property. The trustee’s failure to do so is a rejection of the contract. The 60-day period has expired and if the right of first refusal did not expire by its own terms, it was rejected on July 2, 2006.

The members’ 30-day period to exercise their right of first refusal commenced within a reasonable time after the event that automatically triggered the right of first refusal and the company’s 30-day period had expired without being exercised. The issue of the necessity of further written notice was nto argued and the record is not sufficiently developed to fully address the issue of whether the members’ rights of first refusal, if triggered, expired by failure to exercise it.

The operating agreement is an executory contract and the right of first refusal, if it did not expire earlier, was rejected by the trustee’s failure to assume it on July 2, 2006. The right of first refusal is not enforceable in this bankruptcy case as to the debtor. The trustee’s motion to approve bidding procedures will be granted. The trustee may exercise his discretion to sell the two assets as a package or separately.

In re: Ichiban Inc. (Mayer) No. 06-10316, June 30, 2014; USBC at Alexandria, Va. VLW 014-4-005, 8 pp.

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