An individual bankrupt’s interest in a limited partnership is akin to an option and isn’t an executory contract subject to automatic rejection 60 days after filing, according to Chief Bankruptcy Judge Joseph M. Meier of Boise, Idaho.

On filing in chapter 7, the debtor had a 10.5% interest in a limited partnership. The partnership agreement gave the debtor the right to request distributions from the partnership to cover the debtor’s tax liabilities arising from the debtor’s share of partnership income. The agreement also gave other partners a right of first refusal if a partner were to sell his or her partnership interest voluntarily or involuntarily.

The trustee did not move to assume the partnership agreement within 60 days of filing in 2016. More than 60 days after filing, the trustee did request and did receive distributions from the partnership to cover taxes for the years 2017 and 2018.

For 2019, however, the partnership refused to honor the trustee’s request for a tax distribution. The trustee filed a complaint in bankruptcy court seeking a declaration that the partnership interest was property of the estate and that the trustee was entitled to tax distributions.

The trustee moved for partial summary judgment to declare that the partnership interest was not an executory contract that was automatically rejected 60 days after filing under Section 365(d)(1). Naturally, the partnership took the position that it was an automatically rejected executory contract, leaving the trustee with nothing to sell.

In his February 24 opinion, Judge Meier addressed the question of whether the partnership interest was an executory contract under the so-called Countryman definition. The late Harvard Law School Professor Vern Countryman defined a contract as executory if the obligations of both parties are so far unperformed that a failure by either to complete performance would constitute a material breach excusing performance by the other.

The Right to Distributions

Employing the Countryman test, Judge Meier examined the outstanding obligations of the debtor on the filing date.

Judge Meier said that the right to receive tax distributions “is akin to an option” and that an option is the “grant of a right without any obligation.”

Judge Meier found controlling Ninth Circuit authority in Unsecured Creditors Comm. Of Robert L. Helms Constr. & Dev. Co. v. Southmark Corp. (In re Robert L. Helms Constr. & Dev. Co.), 139 F.3d 702, 705 (9th Cir. 1998) (en banc). In Helms, the Ninth Circuit sat en banc to overrule the circuit’s prior authority, which had held that all options are executory.

Helms said that performance “due only if the optionee chooses at his discretion to exercise the option doesn’t count unless he has chosen to exercise it.” Typically, the appeals court said, the optionee has breached no material obligations “by doing nothing,” that is, by not exercising the option.

Judge Meier interpreted Helms to mean “that an option is non-executory if the optionee need not exercise the option, and if he does nothing, the option lapses without breach.” In the case before him, Judge Meier said that a partner’s failure to exercise the option meant that the option lapsed without breach.

Definitionally speaking, Judge Meier held that the option to take down distributions did not make the agreement executory.  

The Right of First Refusal

The partnership argued that the right of first refusal made the agreement executory.

Reasoning that the failure to exercise a right of first refusal would not breach a performance obligation, Judge Meier held that the first refusal provision did not render the agreement executory.

The Partnership’s Defenses

The partnership offered several defenses, none of which persuaded Judge Meier.

Even if the partnership agreement was a personal services contract under Section 365(c), it didn’t matter because the contract was not executory.

The partnership argued for executory treatment because the state Uniform Partnership Act imposes obligations of good faith and fair dealing. Judge Meier could not “fathom” how a statutory requirement could “singlehandedly” make the contract executory. If it were so, he said, “all contracts would be executory.”

Estoppel didn’t preclude the trustee’s motion, Judge Meier said, because the trustee had not falsely concealed a material fact. Likewise, quasi-estoppel didn’t apply because it was not unconscionable for the trustee to say the agreement was not executory when the partnership had honored distribution requests long after the 60-day window for assumption had passed.

There was no judicial estoppel because the trustee had not changed positions, and there was no waiver because the trustee had previously requested distributions.

Judge Meier granted summary judgment to the extent of declaring that the agreement was valid and enforceable to the extent that it was not executory.

“As to any other reason the Agreement may not be valid or enforceable as to the estate’s interest,” Judge Meier said it “would be a separate issue which is not presently before the Court.” He left open the question of whether the trustee could sell, assume or assign the limited partnership interest.

Observations

Prof. Jay L. Westbrook told ABI that the “Countryman test has greatest difficulties with unilateral contracts like options because failure of the option holder to exercise is almost never a material breach, yet an option, of course, can be of great value, so any trustee would want to assume.”

In his seminal article about executory contracts in 2017, Prof. Westbrook said about limited partnerships that “the material breach test rarely arrives at the right question because the analysis gets lost on the ‘executoriness’ detour.” See Prof. Jay L. Westbrook and Kelsi S. White, “The Demystification of Contracts in Bankruptcy,” 91 Am. Bankr. L.J. 481 (Summer 2017). Prof. Westbrook occupies the Benno C. Schmidt Chair of Business Law at the University of Texas School of Law.

In his article, Prof. Westbrook said that “it is easy to get lost trying to determine whether LLC agreements meet the material breach test for executoriness.” Citing “irreconcilable precedents,” he said that “courts are currently wrestling with that question.”

Under the “functional analysis” proposed in his article, Prof. Westbrook said that “this entire debate can be sidestepped because it is clear that any LLC agreement has at least some remaining obligations rendering it ‘executory’ under the common law definition of the word.”

Using the professor’s approach, a limited partnership agreement would be an executory contract if there were either obligations the trustee would wish to avoid or value that the trustee would wish to collect for creditors. In the case before Judge Meier, the partnership agreement would be executory under Prof. Westbrook’s approach because there obviously was value in the right to claim distributions and, presumably, also in selling the limited partnership interest.

Prof. Westbrook points out in his article how some courts view limited partnership agreements not as contracts but as assets to be handled under Section 541. With respect to those courts that see partnership agreements as assets, this writer would observe that partnership agreements confer contractual rights on limited partners and therefore resemble contracts. Whether those obligations are material under the Countryman test is another question.

A limited partnership is a hybrid creature not easily pigeonholed. It is akin to the ownership of stock in an ordinary corporation, in that the owner has no personal liability for the corporation’s debts. On the other hand, limited partners have rights with respect to the corporation not enjoyed by ordinary stockholders.

A limited partnership interest perhaps more resembles preferred stock. Neither common nor preferred stock is rejectable. As assets that are not contracts, stock can be abandoned or sold with no 60-day limitation for assumption or rejection.

Limited partnership agreements more resemble contracts than stock. If rights and obligations have not been fully performed, why does it matter if they remain only on one side? If a right or an obligation has economic consequences to assume or avoid, why does it matter if they are unilateral?

Courts’ approaches to executory contracts are evolving. In a recent opinion on surety bonds, for instance, the Fifth Circuit said that courts should not foreclose the use of the functional analysis when confronting multiparty contracts. Argonaut Ins. Co. v. Falcon V LLC (In re Falcon V LLC), 44 F.4th 348, 355 at fn. 9 (5th Cir. Aug. 11, 2022). To read ABI’s report, click here.

The bottom line is this: If the court applies the Countryman definition, a limited partnership interest might not be an executory contract. If a court were to employ Prof. Westbrook’s functional analysis, the partnership interest might be executory. Or, a partnership interest might be some peculiar sort of an asset.

Keep in mind that a court employing Prof. Westbrook’s analysis could rule that a partnership interest was rejected automatically if it was not assumed in a timely manner.

Given the confusion about limited partnerships, a trustee or a debtor at the outset of a case should determine whether the partnership interest has value or whether there are onerous obligations. Even if the particular judge sitting on the case has taken a position elsewhere, the trustee should ask the court proactively to decide whether or not the partnership agreement is executory or is another sort of an asset.

The nature of a partnership interest isn’t likely to be resolved soon. And limited partnership agreements are not uniform, so the result in one case might not control in another.

Consequently, a trustee should quickly decide whether to assume, reject, sell, assign or abandon a partnership interest. On the other side of the coin, the limited partnership should move for a declaration that the executory contract was automatically rejected after 60 days or to compel the debtor to abandon the asset.