Texas Bankruptcy Court: Debtor's Non-Economic Rights Under LLC Agreement Are Estate Property Protected by Automatic Stay
The Bankruptcy Code invalidates "ipso facto" clauses in executory contracts or unexpired leases that purport to modify or terminate the contract or lease (or the debtor's rights or obligations under the contract or lease) based solely on the debtor's financial condition or the commencement of a bankruptcy case for the debtor. It also invalidates state law, rather than a contract, that purports to alter the property interests of the debtor. A more difficult situation arises when those interests are on the outer bounds of "property of the estate."
The U.S. Bankruptcy Court for the Southern District of Texas examined the extent to which non-bankruptcy law can modify or terminate the voting and managerial interests that a debtor holds in a limited liability company ("LLC") in In re Envision Healthcare Corp., 655 B.R. 701 (Bankr. S.D. Tex. 2023). The court held that managerial and voting interests become property of the estate on the bankruptcy petition date. It also ruled that the non-debtor members of an LLC who acted postpetition to cancel the debtor's rights under an LLC agreement, based on a state law purporting to terminate such rights upon a bankruptcy filing, violated the automatic stay. Finally, the court denied a motion to compel arbitration of the dispute over the cancellation. According to the court, the determination of what qualifies as property of the estate is within the court's "core" jurisdiction, and permitting arbitration in the case would run against the purposes of the Bankruptcy Code.
The Bankruptcy Estate and the Automatic Stay
An estate is created upon the commencement of a bankruptcy case. The estate includes "all legal or equitable interests of the debtor in property as of the commencement of the case." 11 U.S.C. § 541(a)(1). The scope of the estate is "broad," and it includes tangible and intangible property, causes of action, and property the debtor did not have a possessory interest in, among other things. See United States v. Whiting Pools, Inc., 462 U.S. 198, 205 (1983).
The bankruptcy estate also includes any of the debtor's prepetition property interests (except for certain beneficial interests in trusts) notwithstanding any agreement or applicable non-bankruptcy law to the contrary that: (i) restricts or conditions a transfer of the debtor's interest; or (ii) is conditioned on the debtor's financial condition or the appointment of a trustee or custodian for the debtor; and (iii) effects "a forfeiture, modification, or termination of the debtor's interest in property." 11 U.S.C. § 541(c). Such forfeiture, termination, or modification provisions are commonly referred to as "ipso facto" clauses.
Although the Bankruptcy Code outlines the broad scope of property interests brought into the estate, it lacks guidance on determining what interests in property the debtor had prepetition. Instead, non-bankruptcy (generally state) law defines a debtor's property interests. Butner v. United States, 440 U.S. 48, 54–55 (1979) ("Property interests are created and defined by state law. Unless some federal interest requires a different result, there is no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding."). Where state law and federal law conflict, however, state law yields, especially in circumstances where a private party cannot comply with both laws or where state law stands as an obstacle to the purpose of Congress. See Crosby v. Nat'l Foreign Trade Council, 530 U.S. 363, 372 (2000).
The aggregation of estate property is an essential step before assets can be administered and equitably distributed in bankruptcy. For this reason, estate property is protected from creditor collection efforts by an "automatic stay" upon the commencement of a bankruptcy case. The automatic stay precludes "any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate." 11 U.S.C. § 362(a)(3). One purpose of the stay is to give debtors a "breathing spell" by stopping collection efforts, foreclosure actions, and other harassment. See H.R. Rep. No. 95-595, 340 (1978). The stay also serves to protect creditors, helping to provide "an orderly [reorganization or] liquidation procedure under which all creditors are treated equally." Id.
For most courts, violations of the stay are treated as void. See generally Collier on Bankruptcy ¶ 362.12[1] (16th ed. 2023). However, some courts, including the U.S. Court of Appeals for the Fifth Circuit, have concluded that actions violating the stay are merely voidable rather than void. See In re Jones, 63 F.3d 411 (5th Cir. 1995). The Fifth Circuit reads section 362(d) of the Bankruptcy Code, which permits a court to retroactively annul the automatic stay, together with section 549(a)(1), which authorizes a bankruptcy trustee to avoid unauthorized postpetition transfers, to mean that certain postpetition actions are valid if not voided. See Sikes v. Glob. Marine, Inc., 881 F.2d 176, 179 (5th Cir. 1989).
Arbitration in Bankruptcy
Courts generally enforce arbitration agreements. The Federal Arbitration Act, 9 U.S.C. §§ 1 et seq. (the "FAA"), manifests a "liberal policy favoring arbitration agreements" and marks a Congressionally led departure in the law from prior "judicial suspicion of the desirability and of the competence" of arbitrators. Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, Inc., 473 U.S. 614, 625, 626–27 (1985). Arbitration agreements, with certain exceptions, are "valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract." FAA § 2.
Once a court determines that a valid arbitration agreement exists, however, the court must next consider whether any federal statute or policy forecloses arbitration of the particular claim. Mitsubishi, 473 U.S. at 628. A party opposing arbitration bears the burden to show that "Congress intended to preclude a waiver of judicial remedies for the statutory rights at issue." Shearson/American Exp., Inc. v. McMahon, 482 U.S. 220, 226 (1987). A party can do so by pointing to the statute's text, legislative history, or, importantly, "an inherent conflict between arbitration and the statute's underlying purposes." Id. at 227.
Whether a bankruptcy court is bound to enforce an arbitration clause or demand depends in part on whether the dispute is within the court's statutorily defined "core" jurisdiction. Twenty-eight U.S.C. § 157(b)(2) sets forth a non-exhaustive list of "core proceedings" in bankruptcy. Generally, a proceeding in bankruptcy qualifies as "core" if it "derives exclusively from the provisions of the Bankruptcy Code." In re Nat'l Gypsum Co., 118 F.3d 1056, 1067 (5th Cir. 1997). That is, core proceedings are those that "would arise only in bankruptcy" or that involve "a right created by the federal bankruptcy law." In re Wood, 825 F.2d 90, 97 (5th Cir. 1987). Proceedings that are merely otherwise "related" to the bankruptcy, and therefore could have been brought in another court absent the bankruptcy petition, are non-core proceedings. Id. at 96.
As a rule, bankruptcy courts must uphold arbitration agreements in "non-core" proceedings. Nat'l Gypsum, 118 F.3d at 1066 ("With respect to derivative, non-core matters, the Third Circuit's opinion [that non-core proceedings are arbitrable] … has been universally accepted.") (discussing Hays and Co. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 885 F.2d 1149 (3d Cir. 1989). Courts in the Second, Third, Fourth, Fifth, and Eleventh Circuits have held that, even for "core" proceedings, the relevant inquiry is whether arbitration would conflict with the underlying purposes of the Bankruptcy Code. See, e.g., Nat'l Gypsum, 118 F.3d at 1067 (refusing to find that the arbitration of core bankruptcy proceedings inherently conflicted with the Bankruptcy Code).
Thus, despite the mandate of the FAA, a bankruptcy court may refuse to enforce an arbitration agreement when: (i) "the underlying nature of a proceeding derives exclusively from the provisions of the Bankruptcy Code"; and (ii) "the arbitration of the proceeding conflicts with the purpose of the Code." In re Gandy, 299 F.3d 489, 495 (5th Cir. 2002).
Envision Healthcare
AmSurg Holdings, LLC (the "debtor") is a nationwide operator of ambulatory surgery centers. In 2016, the debtor and Envision Healthcare Holdings, Inc. consummated a merger of equals, forming Envision Healthcare Corporation ("Envision"). On May 15, 2015, Envision and numerous affiliates, including the debtor, filed for chapter 11 protection in the Southern District of Texas.
At the time of filing, the debtor held a 25% interest in Folsom Endoscopy Center ("FEC"), a Delaware LLC that operated as an ambulatory surgery center. In accordance with the terms of the LLC agreement, the debtor's stake secured it voting and related managerial interests in FEC. The LLC agreement also included an arbitration clause.
Several months after the chapter 11 case began, the majority owner of FEC, Gastroenterology Medical Clinic, Inc., and another FEC member (collectively, "GMC") took steps to amend the LLC agreement to strip the debtor it of its prepetition voting and managerial rights. In doing so, they relied on a provision in the Delaware Limited Liability Company Act (the "Del. LLC Act "). Del. Code Ann. tit. 6, §§ 18-101 et seq. Section 18-304(1)(b) of the Del. LLC Act states that "[a] person ceases to be a member of a limited liability company" when, among other events, the person "files a voluntary petition in bankruptcy." The Del. LLC Act defines a "person" as "a natural person, partnership (whether general or limited), [or a] limited liability company." Del LLC Act. § 18-101(14).
The debtor filed a motion to enforce the automatic stay, alleging that GMC's attempt to terminate the debtor's interests under the LLC agreement was a plain violation of sections 362 and 541 of the Bankruptcy Code. GMC responded by demanding arbitration of the dispute.
The Bankruptcy Court's Ruling
The bankruptcy court denied GMC's motion to compel arbitration and voided as barred by the automatic stay the amendment to the LLC agreement that stripped the debtor of its voting and management rights in FEC.
U.S. Bankruptcy Judge Christopher Lopez acknowledged that the LLC agreement contained a valid arbitration clause but rejected GMC's argument that the case involved nothing more than a contract dispute.
Judge Lopez emphasized that "[p]roperty of the estate is a quintessential part of the Bankruptcy Code," and that resolution of the dispute involving the cancellation of the debtor's voting and managerial interests under the LLC agreement was a core bankruptcy proceeding because it required a determination of whether those interests were estate property. Envision, 655 B.R. at 709. Because the Del. LLC Act purported to terminate the debtor's interests, he explained, the question of whether those interests were estate property could be determined only after resolving the "direct conflict" arising between the Bankruptcy Code and the Del. LLC Act. Judge Lopez further concluded that permitting arbitration in this instance would not be consistent with the purposes of the Bankruptcy Code. According to Judge Lopez, "[t]here is nothing in the LLC Agreement to interpret" and the "conflict must be resolved by this Court, not an arbitrator." Id.
Judge Lopez concluded that the debtor's managerial and voting rights under the LLC agreement qualified as legal and equitable interests that are property of the estate. He relied on the Supreme Court's "broad" construction of the estate in Whiting Pools. According to Judge Lopez, the phrase "all legal or equitable interests" in section 541(a)(1) of the Bankruptcy Code is not ambiguous, writing that "[w]e all know what 'all' means." Id. at 709. This plain reading of section 541(a), Judge Lopez reasoned, is bolstered by section 541(c)(1)(B), which provides that estate property includes interests of the debtor that were purportedly terminated because of the commencement of a bankruptcy case.
"[S]tates," Judge Lopez wrote, "cannot legislate estate property away." Id. at 710. A bankruptcy filing, he emphasized, both creates an estate and triggers the automatic stay. These events "occur simultaneously and instantaneously," and "[t]here is no metaphysical moment in time for state law to alter or modify any prepetition rights between the filing of the petition and creation of the estate." Id. at 711. The bankruptcy court accordingly held that, once the debtor filed for chapter 11 protection, its managerial and voting interests under the LLC agreement became part of the estate and were protected by the automatic stay.
Examining the Del. LLC Act and relevant case law interpreting it, Judge Lopez acknowledged that various Delaware courts have upheld either section 18-304 of the Del. LLC Act or other similar ipso facto provisions on the ground that such provisions deprive LLC members merely of management, but not economic, rights. Id. (citing Zachman v. Real Time Cloud Servs. LLC, 2021 WL 1561430, at *2 (Del. Apr. 20, 2021); Milford Power Co., LLC v. PDC Milford Power, LLC, 866 A.2d 738, 740 (Del. Ch. 2004)). For Judge Lopez, however, the distinction drawn by these courts was irrelevant. He determined that section 18-304 of the Del. LLC Act directly conflicts with federal bankruptcy law by purporting to alter property rights included in the bankruptcy estate, thereby violating the automatic stay.
The bankruptcy court noted that its conclusion comports not only with the text of the Bankruptcy Code, but also with other court decisions interpreting similar state laws in this context. Id. at 711–712 (citing Weiss v. All Year Holdings Ltd. (In re All Year Holdings Ltd.), 648 B.R. 434, 456 (S.D.N.Y. 2022), appeal withdrawn, 2023 WL 2944995 (2d Cir. Feb. 1, 2023); Pearce v. Woodfield (In re Woodfield), 602 B.R. 747, 756 (Bankr. D. Or. 2019); Sheehan v. Warner (In re Warner), 480 B.R. 641, 647, 656 (Bankr. N.D. W. Va. 2012)).
The court accordingly declared the amendment to the LLC agreement to be void and restored the debtor's pre-existing voting and managerial rights.
Outlook
There are several takeaways from the bankruptcy court's decision in Envision Healthcare. First, in keeping with the Bankruptcy Code's purpose in administering all of a debtor's interests in property, "wherever located and by whomever held," for the benefit of all stakeholders, "property of the estate" is construed broadly and includes non-economic assets such as management or voting rights under an LLC agreement. Second, the ruling reinforces the supremacy of federal bankruptcy law over non-bankruptcy laws that purport to modify or terminate a debtor's property rights based upon its financial condition or a bankruptcy filing. Finally, Envision Healthcare illustrates that a bankruptcy court has the discretion to deny arbitration of a dispute that is a core proceeding if arbitration would conflict inherently with the purposes of the Bankruptcy Code.
