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Case Style: Nw. Wholesale, Inc. v. Pac Organic Fruit, LLC
Case Number: 90891-5
Judge: Justice Barbara Madsen
Court: IN THE SUPREME COURT OF THE STATE OF WASHINGTON
Plaintiff's Attorney: Erik Samson Bakke, Sr, Andrew Lawrence Kottkamp
Defendant's Attorney: Joshua J Busey
Description: Washington orchardists Harold and Shirley Ostenson (collectively Ostenson) and
California organic fruit broker Greg Holzman (d/b/a Greg Holzman, Inc. (GHI)) formed
Pac Organic Fruit LLC (Pac-0) in 1998. GHI held the majority interest and management
responsibilities under the LLC' s operating agreement. Ostenson was required to rent his
local Washington storage and packing facility to Pac-0, to run that facility, and to obtain
and pay a loan to improve that facility. The business operated from 1998 through 2004
but collapsed in 2005. During 2005, Pac-0 defaulted on its operating line of credit and
1 The legislature amended the WALLCA in May 2015, repealing the provisions discussed herein and reissuing them in a revised but substantively comparable form relevant to the present matter effective January 1, 2016. See LAWS OF 2015, ch. 188. All references to the WALLCA (ch. 25.15 RCW) in this opinion are to the version ofthat act in effect prior to the January 1, 2016 effective date of the noted amendment.
lease payments, Holzman fired Ostenson, and the bank foreclosed on the packing facility.
Thereafter, Holzman, acting as Pac-O's agent, executed a demand promissory note in
favor of GHI and transferred Pac-0' s assets to GHI to satisfy the note.
On January 9, 2007, Ostenson filed a voluntary chapter 11 bankruptcy petition. In
May 2007, a creditor ofPac-0, Northwest Wholesale Inc., filed the present suit against
Pac-0, Ostenson, and GHI, alleging fraudulent conveyance from Pac-0 to GHI. In
response, Ostenson filed cross claims and/or third party claims against Pac-0, Holzman,
GHI, and Total Organic LLC (another Holzman company). Ostenson's claims against
Holzman and his companies (collectively Holzman defendants or HDs) were as a
derivative action on behalf ofPac-0.
On January 24, 2011, the trial court dismissed Northwest Wholesale's claims
following settlement of same. Thereafter, the only remaining claims were Ostenson's
responsive claims against Pac-0 (seven counts) and his derivative claim (count VIII)
against HDs. Trial commenced on July 11, 2011. On July 13, after Ostenson rested,
HDs moved to dismiss count VIII under CR 41 (b )(3). l-IDs argued that under the
W ALLCA, ( 1) a plaintiff asserting a derivative action must be a member of the LLC (see
RCW 25.15.130(1)(d), .370, .375), (2) when Ostenson filed his bankruptcy petition he
was dissociated as a member of the LLC (and thus had only the rights of an assignee, i.e.
right to share in profits, but no management rights) (see RCW 25.15.130(1)(d)(ii),
.250(1)-(2)), and: (3) as Ostenson had been dissociated from membership in Pac-0 by
filing bankruptcy, he lacked authority (standing) to bring a derivative action on behalf of
Pac-0. Ostenson answered the motion arguing that HDs had consented to the derivative
action via a stipulation that was previously entered in the Ostenson's bankruptcy
The trial court took the matter under advisement and directed HDs to go forward
and present their evidence. HDs presented witnesses over the remainder of that day
(July 13) and the next day but did not finish their testimony. The trial court then
continued the matter several times. Finally on September 7, 2012, following additional
briefing, the trial court granted HDs' CR 41 motion. In its October 3, 2012 written
findings and conclusions, the trial court (1) rejected Ostenson's contention that HDs had
waived their CR 41 motion by putting on evidence, (2) rejected Ostenson's contention
that HDs had consented to the derivative action in the stipulation in Ostenson's
bankruptcy proceeding, and (3) ruled that Ostenson relinquished membership in Pac-0
with his bankruptcy filing.
On October 15, 2012 Ostenson filed a motion for reconsideration, arguing for the
first time that federal bankruptcy law preempts W ALLCA regarding dissociation of LLC
members upon filing bankruptcy. The trial court denied Ostenson's motion for
2 In making this argument, Ostenson relied on the W ALLCA, arguing that the consent exception to the dissociation provision found in RCW 25.15.13 0( 1 )(d) applied to bar HDs' challenge to Ostenson's standing to bring the derivative action. Ostenson also argued that "in addition to the RCW [i.e., RCW 25.15.130(1)(d), which provided a consent exception to the dissociation provision], Your Honor, they [(HDs)] should be judicially and equitably estopped" from challenging Ostenson's standing to bring a derivative action. 3 Verbatim Report of Proceeding at 601. Ostenson reasserted those contentions on appeal (consent, judicial estoppel, collateral estoppel, and res judicata), but the Court of Appeals rejected each contention and affirmed the trial court. See Nw. Wholesale, Inc. v. PAC Organic Fruit, LLC, 183 Wn. App. 459,490-93, 334 P.3d 63 (2014), review granted, 182 Wn.2d 1009, 343 P.3d 759 (2015). Ostenson abandoned the issues of consent, judicial estoppel, collateral estoppel, and res judicata in his petition for review.
reconsideration on January 23, 2013. Ostenson appealed, and Division Three affirmed,
holding that HDs did not waive their CR 41 motion to dismiss, HDs did not consent to
Ostenson bringing a derivative action, and federal bankruptcy law governing bankruptcy
estates and executory contracts did not preempt WALLCA's dissociation statute. Nw.
Wholesale, Inc. v. PAC Organic Fruit, LLC, 183 Wn. App. 459, 474-89, 334 P.3d 63
(2014), review granted, 182 Wn.2d 1009, 343 P.3d 759 (2015). Ostenson sought and was
granted review in this court on only two issues: waiver and preemption.
Ostenson argues that HDs waived their right to seek dismissal of his derivative
claim, based on Ostenson's lack of standing, by presenting defense evidence after the
court took HDs' CR 41 motion to dismiss under advisement. 3 Ostenson contends that the
trial court's granting HDs' motion and the Court of Appeals affirmance of same are at
odds with Hector v. Martin, 51 Wn.2d 707, 321 P.2d 555 (1958). That is incorrect.
Hector stands for the proposition that a defendant waives the right to challenge the
sufficiency of the plaintiffs evidence alone by presenting evidence in defense, thereby
3CR 41(b)(3) provides: After the plaintiff, in an action tried by the court without a jury, has completed the presentation of his evidence, the defendant, without waiving his right to offer evidence in the event the motion is not granted, may move for a dismissal on the ground that upon the facts and the law the plaintiff has shown no right to relief. The court as trier of the facts may then determine them and render judgment against the plaintiff or may decline to render any judgment until the close of all the evidence. If the court renders judgment on the merits against the plaintiff, the court shall make findings as provided in rule 52( a). Unless the court in its order for dismissal otherwise specifies, a dismissal under this subsection . . . operates as an adjudication upon the merits.
allowing the court to consider the motion in light of all of the evidence. !d. at 709-10
("[T]he failure of the trial court to rule on such motion before introduction of proof by a
defendant, is tantamount to a denial of the motion. . . . Therefore, this case must be
viewed in the light of all the evidence."). Here, the question in the motion to dismiss did
not turn on the sufficiency of the evidence; the salient facts, the dates of Ostenson's
bankruptcy filing and the subsequent filing of his derivative claim, were not in dispute.
The motion turned on a legal question-Ostenson's standing to bring the derivative claim
in light ofRCW 25.15.130(1)(d) (discussed below). And even if sufficiency ofthe
evidence bore on any pertinent question, nothing indicates that the trial court limited
itself to considering only Ostenson's evidence.
Further, Hector does not address the circumstance here, where the trial court
directed HDs to "go forward" and put on their evidence. 3 Verbatim Report of
Proceeding at 603. Under these circumstances, HDs did not waive their CR 41 motion as
Ostenson contends. The trial court did not err in granting the motion to dismiss under
4 Cf State V. Eide, 2 Wn. App. 789, 791,470 P.2d 220 (1970) (where appellant, at the end ofthe state's case, started to move to dismiss, but was told by the trial judge that he could do so later without waiving his rights and then testified in his own behalf, "defendant had a right to rely upon the assurance of the trial court that he could introduce evidence without waiving his challenge to the sufficiency of the evidence at the close of the state's case").
Ostenson repeats the argument he made below that "[b]oth 11 U.S.C. § 541(c)(1)
and 11 U.S.C. § 365(e)(1) invalidate or render unenforceable ipso facto bankruptcy
clauses." Appellant's Opening Br. at 28; Pet. for Review at 12.6 We begin by noting the
strong presumption against preemption. While the supremacy clause of the United States
Constitution provides that United States law is supreme, notwithstanding any contrary
state law, see Hue v. Farmboy Spray Co., 127 Wn.2d 67, 78, 896 P.2d 682 (1995) (citing
U.S. CONST. art VI, cl. 2), "any consideration of preemption issues 'start[s] with the
assumption that the historic police powers of the States [are] not to be superseded by ...
Federal Act unless that [is] the clear and manifest purpose of Congress."' (Alterations in
original) (quoting Cipollone v. Liggett Grp., Inc., 505 U.S. 504, 516, 112 S. Ct. 2608, 120
L. Ed. 2d 407 (1992).). Accordingly, this court applies "a 'strong presumption against
finding preemption [of State law] in an ambiguous case. . . . State laws are not
superseded by federal law unless that is the clear and manifest purpose of Congress."' !d.
5 HDs argued in part to both the trial court and to the Court of Appeals that Ostenson's preemption assertion, which was first raised in his motion for reconsideration, was untimely. The trial court denied Ostenson's motion for reconsideration. On appeal, Division Three rejected HDs' reasserted timeliness argument, stating, '"By bringing a motion for reconsideration under CR 59, a party may preserve an issue for appeal that is closely related to a position previously asserted and does not depend upon new facts."' Nw. Wholesale, 183 Wn. App. at 480 (quoting River House Dev. Inc. v. Integrus Architecture, PS, 167 Wn. App. 221,231, 272 P.3d 289 (2012)). HDs have not raised the timeliness issue in this court, and we express no opinion on the Court of Appeals discussion of timeliness and issue preservation. 6 Ostenson's arguments regarding the applicability of§ 365 have been a moving target. To the Court of Appeals and in his petition for review, Ostenson argued that§ 365(e)(1) prohibitions applied to the LLC operating agreement here as an executory contract. In his reply in support of his petition, he stated that the operating agreement was not an executory contract and that§ 365 did not apply. But in his supplemental brief, he argues that§ 365(e)(1) does apply and raises two new arguments contending that§ 365(e)(2)'s exception to§ 365(e)(1)'s ipso facto clause prohibitions (discussed below) does not apply here.
(alterations in original) (quoting Progressive Animal Welfare Soc'y v. Univ. of Wash.,
125 Wn.2d 243, 265, 884 P.2d 592 (1994)). Even ifthere is an express preemption
clause, this court will give it "a 'fair but narrow reading."' Id. at 79 (quoting Cipollone,
505 U.S. at 524).- With this presumption in mind, we turn to the statutes at issue.
State Law (W ALLCA) Provisions
RCW 25.15.375 provides:
In a derivative action, the plaintiff must be a member at the time of bringing the action and: (1) At the time of the transaction of which the plaintiff complains; or (2) The plaintiffs status as a member had devolved upon him or her by operation of law or pursuant to the terms of a limited liability company agreement from a person who was a member at the time of the transaction.
(Emphasis added.f Under RCW 25.15.130(1)(d)(ii), a member of a limited liability
company loses his or her membership upon the filing of bankruptcy. The statute
(1) A person ceases to be a member of a limited liability company, and the person or its successor in interest attains the status of an assignee as set forth in RCW 25.15.250(2), upon the occurrence of one or more of the following events:
(d) Unless otherwise provided in the limited liability company agreement, or with the written consent of all other members at the time, the member . .. (ii)files a voluntary petition in bankruptcy.
7 See also RCW 25.15.370, which provides: A member may bring an action in the superior courts in the right of a limited liability company to recover a judgment in its favor if managers or members with authority t9 do so have refused to bring the action or if an effort to cause those managers or members to bring the action is not likely to succeed. (Emphasis added.)
Thus, under Washington law, Ostenson forfeited any right to bring a derivative
action on behalf ofPac-0 when he petitioned for bankruptcy. The LLC agreement did
not allow continued membership but conversely ended the bankrupt petitioning as a
member in the limited liability company. As an assignee, the dissociated member retains
rights to share in profits but loses any management rights. RCW 25.15 .250(2). 8
Ostenson argues only that the dissolution provision of RCW 25.15.13 0( 1 )(d) is
preempted by federal bankruptcy law; to this court he does not otherwise challenge the
provisions or effect of the WALLCA.
Federal Bankruptcy Law Provisions
11 U.S.C. § 541 provides in part:
(a) The commencement of a case under ... this title creates an estate. Such estate is comprised of all the following property, wherever located and by whomever held:
(1) Except as provided in subsections (b) and (c)(2) of this section, all legal or equitable interests ofthe debtor in property as of the commencement of the case.
(Emphasis added.) Section 541 (c)( 1) provides:
Except as·provided in paragraph (2) of this subsection, an interest of the debtor in property becomes property of the estate under subsection (a) (I),
8 RCW 25.15.250(1) and (2)(a) provide in relevant part, "The assignee of a member's limited liability company interest shall have no right to participate in the management of the business and affairs of a limited liability company," and "[a]n assignment entitles the assignee to share in such profits and losses, to receive such distributions, and to receive such allocation of income, gain, loss, deduction, or credit or similar item to which the assignor was entitled, to the extent assigned." 9 Under§ 541(b)(l), the debtor's bankruptcy estate expressly does not include "any power that the debtor may exercise solely for the benefit of an entity other than the debtor," which, by definition, would appear to include a derivative claim, the sole purpose of which is to benefit the entity.
(a)(2), or (a)(5) of this section notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law
(A) that restricts or conditions transfer of such interest by the debtor; or
(B) that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor's interest in property.
State Law Determines Property Interest
As can be seen, a bankruptcy filing triggers the creation of a bankruptcy estate into
which the debtor's property interest devolves. See 11 U.S.C. § 541(a). The threshold i
question, however, of how a debtor's interest is determined turns on application of state
law. See, e.g., Butner v. United States, 440 U.S. 48, 55, 99 S. Ct. 914, 59 L. Ed. 2d 136
(1979) ("Property interests are created and defined by state law."). As the Ninth Circuit
Court of Appeals explained inln re Pettit, 217 F.3d 1072, 1078 (9th Cir. 2000):
Although the question whether an interest claimed by the debtor is "property of the estate" is a federal question to be decided by federal law, bankruptcy courts must look to state law to determine whether and to what extent the debtor has any legal or equitable interests in property as of the commencement of the case.
See also Fisher v. Apostolou, 155 F.3d 876, 880 (7th Cir. 1998) ("The nature of a
debtor's interestin property is determined by state law, but the question whether the
resulting interest should count as 'property of the estate' for§ 541 purposes is an issue of
federal law." (citation omitted)).
In re Farmers Markets, Inc., 792 F.2d 1400 (9th Cir. 1986), is instructive. Therein
the Ninth Circuit Court of Appeals reversed a bankruptcy court's decision that the
debtor's estate ~ould receive liquor licenses unhindered by transfer restrictions imposed
by a state statute~ Id. at 1401-02. In so holding, the court addressed the limits of 11
U.S.C. § 541 and how that provision is to be applied. Noting that the bankruptcy court's
decisions rested upon the misinterpretation of§ 541, the court opined:
[T]he [bankruptcy] court read§ 541(a)(l) to broaden the definition of the property of the debtor's estate. Regardless of§ 541(a)'s scope, reliance upon it is misplaced. That provision merely defines what interests of the debtor are transferred to the estate. It does not address the threshold questions of the existence and scope of the debtor's interest in a given asset. Under [federal bankruptcy law], we resolve these questions by reference to nonbankruptcy law. Section 541 (a) (I) was thus irrelevant to the inquiry.
Id. at 1402 (emphasis added) (citations omitted). The court made clear that the
'"bankrupt estate, insofar as it includes liquor licenses, has only the limited value of the
licenses encumbered as they may be by the terms of the statutes which create the licenses
and provide the conditions of their transfer."' I d. at 1403 (quoting In re Prof'l Bar Co.,
537 F.2d 339, 340 (9th Cir. 1976)). The court held, "Because the estate may take no
greater interest than that held by the debtor, the estate takes the license subject to the
restrictions imposed [by state statute] on the debtor by its transferor." Id.; see also In re
S. Side House, LLC, 474 B.R. 391,402 (Banlcr. E.D.N.Y. 2012) ('"[T]he estate succeeds
to no more interest than the debtor had, and the estate takes its interest subject to the
conditions under which the debtor held the interest.'" (quoting In re Depoy, 29 B.R. 466,
469 (Bankr. N.D. Ind. 1983)).
Farmers also explained that the bankruptcy court had misapplied§ 541(c)(l)(A):
[The bankruptcy court] read this provision to invalidate upon the commencement of bankruptcy proceedings all transfer restrictions on property in which the debtor holds an interest. Section 541(c)(1)(A), however, avoids only those restrictions which prevent transfer of the debtor's property to the estate .... [B]y its terms§ 541(c)(l)(A) applies only to "interest[s] of the debtor in property." ... Because [the state statute] placed no restrictions on the transfer of their entire interests to their respective estates, it does not conflict with§ 541(c)(1)(A).
792 F.2d at 1402 (emphasis added). Applying Farmers to Ostenson's case, his debtor's
bankruptcy estate took his interest as defined, determined, and encumbered according to
state law. In other words, Ostenson's interest that devolved to his bankruptcy estate as
determined by the above Washington statutes was his interest as an assignee and not as a
member of the Pac-0 LLC.
The Court of Appeals reached the same conclusion applying In re Garrison
Ashburn, LC, 253 B.R. 700, 707 (Banlcr. E.D. Va. 2000), which applied a Virginia state
law provision comparable to the above noted Washington statutes dissociating an LLC
member upon the member's filing a banlcruptcy petition. In Garrison-Ashburn, an LLC
member filed for bankruptcy and then sought to execute a real estate contract on behalf of
the LLC. !d. at 704. The other members of the LLC disputed the debtor's right to bind
the LLC because under Virginia law, a member is dissociated upon filing for bankruptcy.
!d. at 707. The debtor retained his economic interest-to share in the profits and losses
of the LLC-but could no longer participate in management. !d. The Garrison-Ashburn
court held that§ 541(c) did not change this analysis:
This result does not offend the Congressional intention behind Sections 54l(c) and 365(c) and (e). These provisions were intended to expand the bankruptcy estate to the maximum feasible extent and to prevent the loss of valuable assets by the operation of ipso facto clauses that terminate valuable leases and other rights upon bankruptcy. Here the estate received the entire interest of the debtor in [the LLC] including its burdens and restrictions. The economic interest, that is the membership interest, remains in the estate and is available for the benefit of creditors. The enforcement of [debtor's] statutory dissociation does not cause a forfeiture of those rights or impair the legal capacity of the company to continue in business.
Id. at 709.10 Garrison-Ashburn reconciled the application of both state law and the
federal bankruptcy code by recognizing and applying the rule that state law defines the
debtor's interest, including dissociation, then§ 541 brings that interest into the debtor's
bankruptcy estate, burdened by whatever state law requires.
10 While Garrison-Ashburn has been criticized by some subsequent cases, see, e.g., In re Klingerman, 388 B.R. 677, 679 (Bankr. E.D.N.C. 2008), other cases agree with GarrisonAshburn's approach. For instance, In re Albright, 291 B.R. 538, 540 n.7 (Bania. D. Colo. 2003), observed: Where a single member files banlauptcy while the other members of a multimember LLC do not, ... the banlm1ptcy estate is only entitled to receive the share of profits or other compensation by way of income and the return of the contributions to which that member would otherwise be entitled. Additional cases that follow Garrison-Ashburn's approach include In re Western Asbestos Co., 313 B.R. 832, 844 (Banl(r. N.D. Cal. 2003) ("The Court views the meaning of 'property,' as used in 11 U.S. C. § 541(c)(1)(B), as something that may be sold or collected to generate funds to be distributed funds to creditors."); In re A-Z Electronics, LLC, 350 B.R. 886, 890 n.12 (Bankr. D. Idaho 2006) (citing Albright with approval); Fotouhi v. Mansdorf, 427 B.R. 798, 802 (Batllcr. N.D. Cal. 201 0) (partner dissociated upon filing banlauptcy); Milford Power Co. v. PDC Milford Power, LLC, 866 A.2d 738, 759-61 (Del. Ch. 2004) (holding that neither§ 365 nor§ 541 preempted state law provisions that deprive barum1pt members of governance rights).
Ostenson cites to cases that have reached a result different than Garrison-Ashburn,
but those cases either do not acknowledge or fail to apply Butner, 11 or are otherwise
distinguishable or not persuasive. For instance, In re First Protection, Inc., 440 B.R. 821,
830 (B.A.P. 9th Cir. 2010), held that under§ 541(a) all of the debtor's rights devolved to
the estate and into the hands of the trustee, including the right to manage and control the
LLC. Id. at 830. On the one hand, such holding arguably made practical sense in that the
decision addressed a single-member LLC and, thus, there were no other members to
manage the LLC if the trustee could not do so, nor were there any other non debtor .
members' interests to be considered and protected. 12 However, the court's application of
§ 541(a) is troubling. The court acknowledged the Butner rule-that a debtor's interest is
determined by state law-but failed to apply that rule. The court acknowledged that a
state statute specifically defined an LLC member's interest as '"a member's share of the
profits and losses"' of the LLC and "'the right to receive distributions of [LLC] assets."'
Id. at 828-29 (quoting ARIZ. REv. STAT.§ 29-601(13)). Nevertheless, the court applied§
541(a)'s language, "all legal or equitable interest" in the bankruptcy estate, broadly to
include not just the interest as above defined by state law but also to include management
rights. Such expansive use of§ 541(a) to define a debtor's interest is contrary to the
11 See In re Klingerman, 388 B.R. 677, 679 (Bankr. E.D.N.C. 2008) (no mention of Butner.and no analysis of threshold determination of debtor's interest as determined by state law); In re LaHood, 437 B.R. 330 (Bania. C.D. Ill. 2010) (same); In re Dixie Mgmt. & Inv., Ltd. Partners, 474 B.R. 698 (Bankr. W.D. Ark. 2011) (same). 12 The Ninth Circuit Banlauptcy Appellate Panel in First Protection acknowledged the distinction made in Albright (quoted above) that a different result would obtain where the LLC member who files a bankruptcy petition belongs to a single member LLC or a multiple member LLC. See First Prot., 440 B.R. at 829 n.13.
Ninth Circuit's analysis in Farmers. See Farmers, 792 F.2d at 1402 (holding that
§ 541(a) addresses only the transfer of debtor's interest to the estate and is "irrelevant" as
to the threshold determination of the existence and scope of the debtor's interest). As this
portion of the First Protection decision does not adhere to Butner, does not follow Ninth
Circuit precedent, and is contrary to the presumption against preemption that this court
applies, see Hue, 127 Wn.2d at 78, we do not find this portion of First Protection
Ostensen cites In re Yonikus, 996 F.2d 866, 869 (7th Cir. 1993), abrogated on
other grounds by Law v. Siegel,_ U.S. _,134 S. Ct. 1188, 188 L. Ed. 2d 146 (2014),
for the proposition that§ 541(a)(1)'s establishment of a bankruptcy estate sweeps broadly
to include every conceivable interest of the debtor "future, nonpossessory, contingent,
speculative, and derivative." But all examples given therein concern money. See id. The
availability to the estate of all of the debtor's economic interest is not at issue in this case.
Ostenson's interest as an assignee devolved to the estate. Further, Yonikus acknowledges
Butner for the proposition that determination of a debtor's interest in property is decided
by state law. See id. (stating, "The question whether an interest claimed by the debtor is
'property of the estate' is a federal question to be decided by federal law; however, courts
must look to state law to determine whether and to what extent the debtor has any legal or
equitable interests in property as of the commencement of the case"). Yonikus does not
Ostenson also relies on In re Daugherty Construction, Inc., 188 B.R. 607 (Banlcr.
D. Neb. 1995), and In re Warner, 480 B.R. 641 (Banlcr. N.D. W.Va. 2012), in which the
respective bankruptcy courts held that§ 541(c)(1) invalidated state statutory and
contractual dissolution provisions. In those cases, the debtor's filing bankruptcy resulted
in the dissolution of the LLC and the termination of all the debtor's interest therein. See
Daugherty, 118 B.R. at 609-11 (statutory dissolution upon bankruptcy filing); Warner,
480 B.R. at 655-56 (bankruptcy triggering dissolution, liquidation, and distribution of
proceeds per operating agreement). Thus, dissolution of the LLC under the state statute
or operating agreement in these cases would result in depriving the estate of all of the
debtor's interest. That is not the situation here.13 As explained above, Ostenson's
banlcruptcy estate took his interest, as determined and encumbered by Washington
statutes, as an assignee. By doing so, his economic interest is preserved in his banlcruptcy
estate and "is available for the benefit of creditors." Garrison-Ashburn, 253 B.R. at 709.
In sum, we find that the Court of Appeals properly followed Garrison-Ashburn,
federal banlcruptcy code, and Washington law.14
13No party has argued that Ostenson's banlauptcy filing resulted in dissolution. But the operating agreement provides that "the Company shall dissolve upon ... the occurrence of ariy event of Member dissociation provided in the Act ... unless the business of the Company is continued with the consent of all of the remaining Members within ninety (90) days following such event." Defs.' Ex. 5 (Pac Organic Fruit LLC Agreement, page 13 (Article 8.1)). Presumably, Pac-0 continued operating with the consent of the remaining member, GHI. 14 Two recent cases from Virginia demonstrate the lack of coherence in this area. In In re Virginia Broadband, LLC, 498 B.R. 90, 93-94 (Bankr. W.D. Va. 2013), a bankruptcy court addressed application of a state statute that dissociated an LLC member upon becoming a debtor in banlauptcy and thereby transformed the member's interest into that of an assignee with only economic interests. Purporting to rely on Garrison-Ashburn, the Broadband court held that the state statute in question was an invalid ipso facto provision under § 541 ( c )(1 )(B) and that the
11 U.S.C. § 365
Ostenson contends that "11 U.S.C. § 365(e)(l) [as wellll U.S.C. § 54l(c)(l)]
invalidate or render unenforceable ipso facto bankruptcy clauses." Pet. for Review at 12.
The relevant statute, 11 U.S.C. § 365 provides in relevant part:
(e)(l) Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on
(B) the commencement of a case under this title ...
(2) Paragraph (1) of this subsection does not apply to an executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assigmnent of rights or delegation of duties, if-(A)(i) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to the trustee or to an assignee of such contract or lease, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and (ii) such party does not consent to such assumption or assignment.
(Emphasis added.) 15
debtor's economic and noneconomic interests in the LLC became property ofhis banlm1ptcy estate. Jd. at 96-97. However, in In re Williams, 455 B.R. 485 (Bankr. E.D. Va. 2011), another court, applying the same statute and also purporting to apply Garrison-Ashburn, came to the opposite conclusion. The Williams court held that§ 541(c)(l) "clearly controls" and that the two debtors' interests vested in their respective estates, but that such interest was determined by the state statute. Thus, as defined by the state statute, a dissociated member retained only economic rights, and since both LLC members had been dissociated through bankmptcy and no one was left to wind up the affairs ofthe LLC, the court would appoint a liquidating tmstee to do so. Id. at 501-02. Such ambiguities support applying a "'strong presumption"' against finding preemption ofRCW 25.15.130(l)(d)'s dissociation provision. Hue, 127 Wn.2d at 78 (quoting Progressive, 125 Wn.2d at 265). 15 Similarly,§ 365(c) provides in part:
Section 365 applies to executory contracts.16 As First Protection explains,
"Generally, the bankruptcy estate automatically succeeds to a debtor's assets. However,
because an executory contract is both a potential asset and a potential liability of the
debtor it is treated differently." 440 B .R. at 83 0.17 Notably, "if the operating agreement
is an executory contract ... § 365 governs the trustee's rights rather than§ 541(c)(l). In
The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if-(l)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and (B) such party does not consent to such assumption or assignment .... (Emphasis added.) 16 Ostenson argues in his petition that the LLC's operating agreement is an executory contract and thus subject to the ipso facto prohibition in§ 365(e)(1), but in his reply he contends that § 365 does not apply. Then he reasserts in his supplemental briefthat § 365(e)(1) does apply while raising two new arguments to avoid§ 365(e)(2)'s exception to§ 365(e)(l)'s prohibition. In any event, as the Court of Appeals held, it ultimately does not matter whether the Pac-0 operating agreement qualifies as an executory contract because, even if it does, under the circumstances of Ostenson's case§ 365(e)(2) would apply to negate the application of§ 365(e)(1)'s prohibition, as explained herein. 17 Executory contracts do not automatically devolve to the bankruptcy estate. "The trustee's power to reject those executory contracts which he finds burdensome to the bankrupt's estate is an extension of his power to renounce title to and abandon burdensome property which is already a part of the estate. Because executory contracts ... involve future liabilities as well as rights, however, an affirmative act of assumption by the trustee is required to bring the property into the estate in order to ensure that the estate is not charged with the liabilities except upon due deliberation. Thus, executory contracts ... -unlike all other assets-do not vest in the trustee as of the date of the filing of the bankruptcy petition. They vest only upon the trustee's timely and affirmative act of assumption." First Prot., 440 B.R. at 830 (alterations in original) (quoting In re Lovitt, 757 F.2d 1035, 1041 (9th Cir.1985) (citations omitted)).
that event, the restrictive provisions under [a state] LLC Act or the operating agreement
that affect the transfer of [d]ebtor's rights and interests in [an LLC] may be enforced
through operation of§ 365[(e)(2)] in some instances." Id. at 830-31.
Whether a contract is executory within the meaning of the Bankruptcy Code is a
"question of federal law." Id. at 831 (citing In re Alexander, 670 F.2d 885, 888 (9th
Cir.1982)). "A contract is executory only when the 'obligations of both parties are so far
unperformed that the failure of either party to complete performance would constitute a
material breach and thus excuse the performance of the other."' Id. (quoting In re
Ehmann, 319 B.R. 200, 204 (Bankr. D. Ariz. 2005)).
Here, the Court of Appeals analyzed the obligations in the Pac-0 operating
agreement and noted that while they "may suffice to create an executory contract," the
court ultimately "need not decide" whether the Pac-0 operating agreement is an
executory contract because the court otherwise held that"§ 365(e) of the bankruptcy code
excuses further performance under the agreement." Nw. Wholesale, 183 Wn. App. at
487-88; see In re Tsiaoushis, 383 B.R. 616, 620 (Bankr. E.D. Va. 2007) (Mem. Op.)
(noting that the "final step" in any analysis of executory contracts under § 365 is the
applicability of§ 365(e)(2)'s exemption from§ 365(e)(l)'s ipso facto prohibition). To
address this issue, Division Three applied Finkelstein v. Security Properties, Inc., 76 Wn.
App. 733, 888 P!2d 161 (1995). See Nw. Wholesale, 183 Wn. App. at 488.
Ostenson asserts that Division Three's reliance on Finkelstein was error because
that case addresses partnerships and not LLCs. Pet. for Review at 17. But Division
Three's reliance on a partnership case was not improper. See Tsiaoushis, 383 B.R. at 618
(noting because LLC's are relatively new statutory creations, "decisions concerning
partnership agreements are helpful").18 Accordingly, Division Three did not err in
applying by analogy a partnership case that addressed application of section§ 365(e)(2).
In Finkelstein, Division One held that a state law provision that dissolved a
general partnership upon the filing of bankruptcy by any of the partners was not
superseded by§ 365(e)(1)'s invalidation of ipso facto provisions. Therein, Finkelstein
was a minority partner in two related general partnerships, each of which served as
general partners for several limited partnerships. Finkelstein filed for bankruptcy under
chapter 11 and later converted to chapter 7. Before the bankruptcy filing, each general
partnership agreement provided that the partnership would not dissolve or terminate upon
the death, incapacity, or bankruptcy of any partner. After Finkelstein filed bankruptcy,
each general partnership then amended its partnership agreement to exclude Finkelstein
as a partner. Finkelstein then sued the general partnerships for an accounting and breach
of fiduciary duties and brought a derivative action on behalf of several of the limited
partnerships. The trial court dismissed Finkelstein's claims on statute of limitations
grounds, and Division One affirmed, holding in part that state partnership law was not
superseded by federal bankruptcy law, that the partnerships dissolved under state
partnership law when Finkelstein bankruptcy case was converted to chapter 7, and that as
18 See also Sally S. Neely, Partnerships and Partners and Limited Liability Companies and Members in Bankruptcy: Proposals for Reform, 71 AM. BANKR. L.J. 271, 317 (1997) ("[B]ecause of the similarities between LLCs and partnerships in this area of inquiry, the cases [involving partnerships] also provide guidance regarding the appropriate consequences of the bankruptcy of a member or member-manager of a[n] LLC.").
a former partner Finkelstein had no standing to bring breach of fiduciary duty claims or a
derivative action on behalf of the limited partnerships. Finkelstein, 76 Wn. App. 733.
Relevant here, noting that courts have "'generally assumed that partnership
agreements are ... executory contracts,"' Division One held that "[debtor's] bankruptcy
trustee was not free to assume the contract under § 3 65 because the other partners were
not obligated to accept such an assumption." !d. at 736-37 (quoting In re Cutler, 165
B.R. 275, 279-80 (Bania. D. Ariz.1994)). This is so because "[p]artnerships are
voluntary associations, and partners are not obligated to accept a substitution for their
choice of partner." !d. at 737. The court additionally held that "[t]he restraint on
assumability also makes the deemed rejection provision of§ 365[(d)(l)] inapplicable to
the partnership agreement. Therefore,§ 365(e)'s invalidation of ipso facto provisions
does not apply, and state partnership law is not superseded." !d. (citation omitted). The
Finkelstein court relied on a Fifth Circuit case, In re Phillips, 966 F.2d 926, 935 n.ll (5th
Cir. 1992), which noted that
[C]ourts which have ruled that§ 365(e) supersedes state partnership law have failed to apply§ 365(e)(2) to their analysis. Section 365(e) was designed to invalidate banlm1ptcy termination clauses (ipso facto provisions) in contracts. Section 365( e )(2) clarifies Congress' intention to prevent only private contracts from counteracting the Banlauptcy Code, not to prevent state law, such as partnership law, from determining the status of a partnership.
Finkelstein, 76 Wn. App. at 737 n.3. Division One further explained, "Section 365 is
clearly not applicable to the executory portion of the partnership contract [i.e., described
as management rights and duties] because partnership agreements are purely consensual
and the freedom of the partners to associate and dissociate is the heart of partnership
law." !d. at 738. Accordingly, the Finkelstein court held that§ 365 was not applicable
and did not supersede state partnership law. !d.
The only ~uties owed to [debtor] after his removal from the partnership were the duties to account and pay to him (or his estate) the value of his share. [Debtor] ceased to be a member of the partnership upon dissolution, and has no rights against the remaining partners for their continuing business. It follows that he has no claims against the remaining partners for any alleged subsequent self-dealing. For the same reasons, we also affirm the trial court's dismissal of[debtor's] derivative action.
!d. at 740 (emphasis added).
Here, the Court of Appeals sustainably relied on Finkelstein in holding that§ 365
did not preempt Washington law that removed Ostenson as a member of Pac-0 upon his
bankruptcy filing. See Nw. Wholesale, 183 Wn. App. at 489. The same rights of
voluntary association on which the Finkelstein decision turned apply equally to LLC
membership. Se(! Daugherty Constr., 188 B.R. at 611 ("Like a partnership, members of
the LLC have voluntarily associated in a business enterprise and the relationship among
members may be personal in character.''); see also Sally S. Neely, Partnerships and
Partners and Limited Liability Companies and Members in Bankruptcy: Proposalsfor
Reform, 71 AM. BANKR. L.J. 271,312 (1997) (same); First Prot., 440 B.R. at 832 (plain
language of§ 365(c)(l) and§ 365(e)(2)(A) makes clear that the provisions are not for the
debtor's protection). "These sections[§ 365(c)(1) and§ 365(e)(2)(A)] were designed 'to
protect non-debtor third parties whose rights may be prejudiced by having a contract
performed by an :entity other than the one with which they originally contracted."' First
Prot., 440 B.R. at 832 (quoting In re C. W Mining Co., 422 B.R. 746, 761 (B.A.P. lOth
Cir. 2010)). The WALLCA clearly protects the voluntary association rights ofnondebtor
LLC members. For instance, while RCW 25.15.250 authorizes the assignability of a
member's LLC interest "in whole or in part," that statute nevertheless expressly protects
the associational interests of the remaining members by providing:
The assignee of a member's limited liability company interest shall have no right to participate in the management of the business and affairs of a limited liability company except . .. [u]pon the approval of all of the members of the limited liability company other than the member assigning his or her limited liability company interest.
RCW 25.15.250(l)(a) (emphasis added). Similarly, RCW 25.15. 260, which addresses
the right of an assignee to become a member, states in pertinent part, "An assignee of a
limited liability company interest may become a member upon ... [t]he approval of all of
the members of the limited liability company other than the member assigning his or her
limited liability company interest." RCW 25.15.260(1)(a) (emphasis added). Given the
strong protection ofLLC members' voluntary associational interests, comparable to
partnerships, the Court of Appeals did not err in applying Finkelstein to Ostenson's case
and affirming the dismissal of his derivative claim.
Ostenson does not effectively argue otherwise. He cites to Summit Investment &
Development Corp. v. Leroux, 69 F.3d 608 (1st Cir. 1995) for the proposition that
§ 541(c)(l) and§ 365(e)(l) invalidate or render unenforceable ipso facto bankruptcy
clauses. But the Summit court addressed only § 365( e) and did not undertake any
analysis of§ 541. !d. at 614 n. 8. And while the First Circuit indeed held in Summit that
§ 365(e) preempted a Massachusetts statute comparable to RCW 25.15.130(1)(d)(ii), the
Ninth Circuit expressly rejected Summit's approach in In re Catapult Entertainment, Inc.,
165 F.3d 747 (9th Cir.), cert. dismissed, 528 U.S. 924 (1999). The Ninth Circuit Court of
Appeals noted that under the statute's plain language, while§ 365(e)(l) nullifies ipso
facto clauses, "§ 365( e )(2)(A) expressly revives 'ipso facto' clauses" under the
circumstances noted therein. Id. at 753 n.6. The Ninth Circuit held, "[W]here applicable
nonbankruptcy law makes an executory contract nonassignable because the identity of
the nondebtor party is material, a debtor in possession may not assume the contract
absent consent of the nondebtor party." Id. at 754-55. As noted, RCW 25.15.250(1)(a)
and RCW 25.15.260(1)(a) of the WALLCA require the express approval ofthe LLC
nondebtor members regarding any transfer or assumption of member management rights.
To the extent the LLC operating agreement may qualify as an executory contract
concerning management, the noted "applicable law excuses a party, other than the debtor
[i.e., the nondebtor members], ... from accepting performance from or rendering
performance to ... an assignee," and "such party [i.e., the nondebtor members have] not
consent[ed] to such assumption or assignment." 11 U.S.C. § 365(e)(2). Accordingly,§
365(e)(2)'s exception to§ 365(e)(1)'s prohibition of ipso facto provisions applies.
19 Ostenson raises two new issues in his supplemental brief. First, he contends that because his bankruptcy petition was filed under chapter 11 (reorganization), he is a debtor in possession and thus he may be treated as the same entity before and after his bankruptcy filing. Because there will be no assignment of the operating agreement to a different entity, the§ 365(e)(2) exception to§ 365(e)(1)'s prohibition to ipso facto provisions is not triggered. Second, Ostenson contends that the stipulation entered in his bankruptcy proceeding qualifies as the required consent under § 365(c)(1)(A) and§ 365(e)(2) and thus the§ 365(e)(2) exception is not triggered. See Pet'rs' Suppl. Br. at 17-20. We decline to address Ostenson's newly raised arguments. "Under the No. 90891-5
Outcome: We conclude that HDs did not waive their CR 41 motion to dismiss and that
federal bankruptcy law, 11 U.S.C. §§ 541 or 365, does not preempt RCW
25.15.130(1)(d)'s dissociation provision. As to the latter issue, we hold that state law defines what the bankruptcy debtor's interests are and that § 541 brings such interests into the bankruptcy estate, burdened by whatever state law requires. Additionally, if executory contracts are involved, § 365 applies to determine what may be done with such contracts. But here, the express protections of associational rights ofnondebtor members found in the WALLCA triggers§ 365(e)(2)'s exception, rendering§ 365(e)(1)'s prohibition against ipso facto clauses inapplicable. We affirm.
Comments: This case concerns whether a 'debtor who has filed a voluntary bankruptcy petition may maintain a derivative action on behalf of a limited liability company (LLC), of which the debtor was a former member. The primary inquiry addresses the interplay of federal bankruptcy law and portions of the Washington Limited Liability Company Act (WALLCA), chapter 25.15 RCW, and whether the state provisions are superseded under the circumstances of this case; specifically, whether 11 .S.C. §§ 541 or 365 preempt RCW 25.15.130(l)(d). 1 We hold that the dissociation provision found in RCW 25.15. 13 0( 1 )(d) is not preempted by federal bankruptcy law and affirm the dismissal of the former LLC member's derivative claim under the facts of this case.