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Both Delaware law and the bankruptcy code generally permit the assignment of contractual obligations and interests. However, in Northrop Grumman Technical Services Inc. v. The Shaw Group Inc. (In re IT Group Inc. Co.), when one of the four members of a limited liability company filed for bankruptcy and subsequently attempted to transfer its rights under an LLC operating agreement to one of the other LLC members, a dispute arose among the four LLC members. This dispute focused on two provisions in the operating agreement — a default provision and a right of first refusal. THE FACTS The IT Group Inc., The Shaw Group Inc., Northrop Grumman Technical Services Inc. and Wackenhut Services Inc. were members of The Space Gateway Support LLC. Their rights and obligations as members of the LLC were set forth in an operating agreement. After filing for bankruptcy, IT Group attempted to transfer its rights under the operating agreement to Shaw. Consequently, a dispute arose over the enforceability of the operating agreement’s default provision and right of first refusal. The bankruptcy court held that the default provision was not enforceable as an ipso facto clause under � 365(e)(1) of the bankruptcy code (prohibiting termination of a contract by reason of a party’s filing of a petition in bankruptcy) and that assumption and assignment of the debtor’s bare economic interest in the LLC were subject to the right of first refusal set forth in the LLC operating agreement. On appeal to the district court, Northrop and Wackenhut contended that the bankruptcy court erred in concluding that the default provision was unenforceable. Specifically, Northrop and Wackenhut asserted that the default provision was enforceable under a statutory exception to � 365(e)(1). They contended that as the court had already found that the debtor was in default insofar as its membership rights were concerned, the debtor should also be in default insofar as its economic interests in the LLC were concerned. By its cross-appeal, Shaw and the debtor asserted that the bankruptcy court erred as a matter of law when it concluded that the transfer was subject to Northrop’s right of first refusal. Specifically, Shaw and the debtor contended that the right of first refusal was also an ipso facto clause which impermissibly restricted or conditioned assignment and was thus in conflict with 11 U.S. Code � 365. They asserted that the debtor’s economic interest could be assumed and assigned so long as Shaw provided adequate assurances of future performance. THE DEFAULT PROVISION The operating agreement’s default provision stated that if an LLC member defaulted under the operating agreement by virtue of the fact that it had filed a bankruptcy petition, other members of the LLC would be entitled to exercise buyout rights to purchase the debtor member’s economic interest. Upon the occurrence of a member bankruptcy default, the value of the debtor member’s economic interest in the LLC would be capped under the operating agreement at an amount equal to the value of accrued capital attributable to the debtor member as of the date of the bankruptcy petition. Because the operating agreement conditioned the buyout rights of the non-debtor members on the existence of a default, the ipso facto nature of the member bankruptcy default called into question whether the debtor member might, in fact, be entitled to keep its ongoing rights to profits and losses from the LLC. Under 11 U.S.C. � 365(e)(1), certain contractual default provisions are not enforceable. Specifically, � 365(e)(1) provides that an executory contract or any right or obligation under such contract may not be terminated or modified solely because of a provision in such contract which is triggered upon the commencement of a case under the bankruptcy code or the insolvency or financial condition of the debtor at any time before the closing of the case. However, � 365(e)(2)(A) identifies an exception to the bankruptcy code’s ipso facto provision: If applicable law excuses a party to the contract (other than the debtor) from accepting performance from or rendering performance to the assignee and such party does not consent to such assignment, the contract may be terminated or modified. Under Delaware law, members of an LLC are permitted to assign their bare economic interests in an LLC to another entity and the assignee is entitled to, inter alia, the profits, losses and distributions to which the debtor was entitled. Therefore, applicable law did not excuse Northrop from rendering economic performance to Shaw under the operating agreement. Accordingly, the court found that the exception outlined in � 365(e)(2)(A) did not apply. Thus, the court held that the default provision in the operating agreement was unenforceable as an ipso facto provision. RIGHT OF FIRST REFUSAL Similarly, Northrop and Wackenhut argued that the right of first refusal was in conflict with � 365 of the bankruptcy code because it was essentially an ipso facto clause. However, the court found that the right of first refusal was triggered not by the debtor’s filing for bankruptcy, but by the debtor’s transfer of its interest in the LLC. Because the right of first refusal was thus not an ipso facto provision, the court held that it was enforceable notwithstanding the fact that the debtor was in bankruptcy. Northrop and Wackenhut also argued that the right of first refusal was not enforceable under 11 U.S.C. � 365(f). Section 365(f) of the bankruptcy code provides that “notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts or conditions the assignment of such contract or lease, the trustee may assign such contract or lease … only if (A) the trustee assumes such contract or lease in accordance with the provisions of this section; and (B) adequate assurance of future performance by the assignee of such contract or lease is provided, whether or not there has been a default in such contract or lease.” Noting that there was no precedent in the 3rd U.S. Circuit Court of Appeals but that bankruptcy courts retain some discretion in determining whether provisions that do not explicitly prohibit assignment qualify as de facto anti-assignment clauses, the district court agreed with the bankruptcy court that the right of first refusal was not an unenforceable restraint on assignment. Specifically, the court stated that enforcing the right of first refusal would not “hamper the debtor['s] ability to assign the property or foreclose the estate from realizing the full value of the debtor['s] interest” in the LLC. Additionally, the court noted that public policy did not preclude enforcement of the right of first refusal on the ground that allocation procedures implicated by the exercise of such a right were too onerous. In fact, the court stated that when the asset subject to the right of first refusal is part of a package, the holder of the right of first refusal is entitled to an allocation of the purchase price. To conclude that the procedures render the right of first refusal unenforceable would be to usurp a cognizable property right set forth by state law, which would be counter to sound public policy. Thus, while the court found that the default provision was an ipso facto clause, it did not find the right of first refusal to be an ipso facto clause, because it was not triggered by the filing of a bankruptcy petition but by the debtor’s transfer of its interest in the LLC. Additionally, the court stated that the right of first refusal was not an unenforceable restraint on assignment or contrary to public policy. Therefore, Northrop was entitled to exercise its first refusal right but not its buyout rights. If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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