MILFORD POWER v. PDC MILFORD POWER

OPINION

STRINE, Vice Chancellor.

The plaintiffs in this case, Milford Power Company, LLC and the owner of a 95% interest in Milford Power, Milford Holdings LLC, bring this case seeking a declaration that defendant PDC Milford Power, LLC ("PDC") has lost all membership interest in Milford Power as a result of its filing of a petition for bankruptcy on February 27, 2004. Although PDC's bankruptcy petition was dismissed, the plaintiffs nonetheless allege that the plain terms of the Milford Power LLC Agreement automatically divested PDC of its membership interest in Milford Power upon PDC's filing of its bankruptcy petition and assigned its membership interest and all attendant rights to Milford Holdings, as the sole remaining member of Milford Power. Furthermore, the plaintiffs allege that the plain terms of the LLC Agreement dictate that this assignment occurred without any obligation on the part of Milford Power, as assignee, to pay PDC any compensation for its prior interest.

For its part, PDC contends that the doctrine of unclean hands prevents the plaintiffs from relying on the ipso facto clause in the LLC Agreement because PDC sought refuge in bankruptcy when plaintiffs' affiliates improperly sought to foreclose on PDC's membership interest. In addition, PDC argues that the ipso facto clause in the LLC Agreement is preempted by certain provisions of the Federal Bankruptcy Code.

In this opinion, I conclude that PDC's unclean hands defense does not bar the plaintiffs from relying upon the ipso facto clause in the LLC Agreement. But, I also conclude that the ipso facto clause is preempted to the extent that it would deprive PDC of the economic rights available to an assignee of an LLC membership interest under § 18-702(b)(2) of the Delaware LLC Act. By contrast, the ipso facto clause is enforceable insofar as it divests PDC of its right to participate as a member in the governance of Milford Power. This conclusion rests largely on my adoption of the reasoning of the United States District Court for the District of Delaware in In re IT Group, Inc.1

I. Factual Background

Milford Power is an LLC that was established to own and operate a natural gas-fired electric generation facility with 540 megawatt capacity (a.k.a., a "power plant") in Milford, Connecticut. When created, Milford Power's ownership was split up between what can be regarded as two different parties in interest. Through two separate affiliates, a large public company, El Paso Corporation, held 95% of Milford Power's membership interests and was the party that put up substantial cash to help fund the construction of the power plant. For the sake of simplicity, I herein refer to these affiliates solely as El Paso.

The other member of Milford Power was PDC. PDC is a single-purpose entity that was formed by a Texas-based development firm, Power Development Company, LLC. PDC alleges that it played an important role in developing the idea of building the power plant in Milford, Connecticut and helping Milford Power obtain the necessary approvals. In connection with this role, PDC received a 5% membership interest in Milford Power.

The LLC Agreement vests the power to manage Milford Power in the members. The Agreement creates several committees to manage the firm and each member, including PDC, is given the right to appoint representatives.2

Unanimous consent of the members is required in order for Milford Power to engage in certain activities, including mergers, repurchases of member units, or bankruptcy filings.3 As to certain other important decisions, a super-majority vote of the members of relevant committees is required.4 It is unclear from the text of the LLC Agreement whether El Paso had sufficient voting power on any committee to meet this threshold without support from the PDC member. For still other decisions, a mere majority vote of the members is required.5 On a day-to-day basis, the LLC Agreement contemplates the appointment of officers to conduct the company's operations and by its own terms, created a position of General Manager.

From the get-go, Milford Power was substantially leveraged. Although El Paso contributed over $78 million to fund a bridge loan, Milford Power obtained an additional loan (which eventually became non-recourse) for over $271 million from a syndicate of lenders (the "Lenders"). Although this debt was not an obligation of PDC itself, PDC's membership interest in Milford Power was pledged as collateral to secure the loan, as were the member interests controlled by El Paso.

As far as can be ascertained from the record, this debt matured and was due and owing as of October 1, 2002. But Milford Power defaulted.

The Lenders agreed to a forbearance to give Milford Power more time. When that time ran out, Milford Power remained in default.

What happened precisely at this stage is unable to be determined on this record with accuracy. The parties have burdened me only with excerpts from pleadings filed in an action in a New York court that is related to this case. I have therefore attempted to distill from these documents the essence of what occurred and of what is indisputable.

According to PDC, the Lenders made certain promises during 2003 to work with Milford Power to restructure the defaulted debt. But then, says PDC, the Lenders changed direction and permitted El Paso to exit the Milford Power scene in exchange for El Paso's member interests in Milford Power and certain additional, unspecified consideration. El Paso transferred its member interests to a new entity ultimately controlled by the Lenders. The Lenders sought approval from the Federal Energy Regulatory Commission for the transfer of El Paso's interest in Milford Power to their new vehicle, Milford Holdings. PDC did not object to that request.

In their application, the Lenders indicated that their intention was not to become long-term operators of the power plant but instead to find a third-party buyer. According to PDC, the Lenders led it to assume that PDC would be able to retain its membership interest in Milford Power and receive a 5% share of any later sale of the entity.

But instead of doing so, the Lenders — or so PDC contends — took an entirely different tack. Initially, Milford Holdings purported to bind Milford Power to a management contract under which the firm's operations would be managed by an entity named CPV Milford, LLC, which is the managing member of Milford Holdings. Allegedly, this decision was made without any input from PDC, as have other allegedly important business decisions. But the FERC application, to which PDC supposedly consented, describes at length the substantial authority that would be vested in CPV Milford, a description that was designed to persuade the FERC that Milford Holdings (and its investors, the Lenders to Milford Power) would not be deemed a public utility, in part because CPV Milford would have "complete discretionary managerial authority over the Project Company and be responsible for the management of all activities of the Plant."6

Then, the Lenders began to take steps to foreclose on PDC's membership interest by scheduling a foreclosure sale. As of that time period, Milford Power owed the Lenders in the vicinity of $250 million.

What PDC did in response to the foreclosure is what gives rise to this case. Rather than sue the Lenders in an appropriate state court to enjoin the foreclosure sale, PDC filed a voluntary petition for bankruptcy in the United States Bankruptcy Court for the District of Massachusetts on February 27, 2004. In its filing, PDC indicated its intention to file an adversary proceeding against the Lenders alleging, among other things, that they were improperly acting to deprive PDC of its membership interest in Milford Power.

The Lenders moved to dismiss PDC's filing on grounds that cannot be discerned from the record before me. On April 27, 2004, the Bankruptcy Court granted the motion to dismiss in a handwritten order that is devoid of explication. On June 2, 2004, the Bankruptcy case was officially closed.

A few weeks later, two lawsuits were filed. In the Supreme Court of the State of New York, the Lenders filed an action seeking to foreclose on PDC's interest in Milford Power. The Lenders alleged that Milford Power owed over $250 million to them as of June 2004 and that the money the Lenders would raise in a sale of PDC's interest should be used to reduce that amount. El Paso was also named as a party because it allegedly held a subordinate security interest in PDC's 5% interest.7

That same day, Milford Power brought this action for declaratory judgment. In this action, later joined by Milford Holdings as an intervening plaintiff, Milford Power sought a declaration that PDC had automatically assigned its membership interest in Milford Power to Milford Holdings when it filed for bankruptcy. In the complaint, the plaintiffs relied on Article 11.2 of the LLC Agreement — the "Ipso Facto Clause" — which reads in pertinent part as follows:

The LLC Agreement defines the term "Withdrawn Member" in Article 11.9, which reads as follows:

Through this action, the plaintiffs seek a declaration that PDC is a "Withdrawn Member" and that Milford Power is its attorney-in-fact for the purpose of transferring PDC's interest to Milford Holdings. During the course of the case, it has become clear that the plaintiffs do not believe that any consideration is owed to PDC for this transfer.

PDC reacted to the New York and Delaware suits in a related manner. In the New York action, PDC alleged that the Lenders, in concert with Milford Holdings, had breached certain duties they allegedly owed to PDC, and therefore that the Lenders should be precluded from foreclosing on PDC's member interest in Milford Power and were liable to PDC for damages.

Meanwhile, in this action, PDC takes the position that its bankruptcy filing was caused by improper conduct by the Lenders (a non-party to this action) and by Milford Holdings (an entity affiliated with the Lenders that is a party to this action). Candidly, it is difficult to discern exactly what misconduct the Lenders or Milford Holdings engaged in that could, in the end, be found to constitute a cognizable breach of legal or equitable duties owed to PDC.

As pled and as recounted in an affidavit filed by PDC's manager in this court, PDC contends that the Lenders and Milford Holdings have engaged in "a pattern of conduct demonstrating a concerted and improper predatory plan to divest and take PDC's 5% interest prior to any sale of Milford Power in order to reap 100% of the proceeds from" the sale of the power plant for themselves.10 The theory of their approach seems to be that the Lenders think that 1) the power plant is worth substantially more than the over $250 million owed by Milford Power, 2) that El Paso's relinquishment of its equity, and (PDC suspects) payment of some additional cash, fully satisfied the debt owed by Milford Power, and 3) that the Lenders are trying to steal PDC's rightful 5% of the upside from a sale of the power plant.

To a judge who handles a lot of business cases, the picture that is painted seems intuitively implausible. It presupposes that El Paso, which had put up substantial cash equity and which owned a 95% interest in Milford Power, made a completely irrational decision to not only give up its interest but to pay additional cash to do so, even though the power plant had a sale value that would easily pay off the debt11 and produce a huge upside. In fact, in its papers, PDC argues that its 5% interest was worth $9 million. When I asked for clarification, I was told that this was the value assuming a full pay off of the over $250 million owed to the Lenders. If that is true, PDC is alleging that Milford Power has an enterprise value of $430 million and therefore that El Paso had, in fact, fallen off the proverbial turnip truck before it decided to exit its investment in Milford Power.

In a confusing post-argument submission, PDC attempts to prove that the power plant will generate over $82 million in guaranteed payments a year from a Cost of Service Agreement between the power plant project and ISO New England, Inc. for the duration of the plant's service life. It is not at all clear what this means; in particular, whether this sum was a total or the amount that would be received by Milford Power in excess of the costs of operating the plant. In any event, PDC does not dispute that the Lenders are currently due over $250 million.

II. The Plaintiffs' Motion For Summary Judgment

The plaintiffs' motion for summary judgment is presented in a straightforward manner. They argue that the plain language of the Milford Power LLC Agreement operated to automatically turn PDC into a "withdrawn member"12 and to transfer its member interest to Milford Holdings as of the time PDC filed for bankruptcy. The provision of the LLC Agreement that so provides is, they argue, fully consistent with Delaware law, because an express provision of the Delaware Limited Liability Company Act provides:

Furthermore, the plaintiffs argue that the terms of the LLC Agreement make it clear that as a "withdrawn member" PDC had no further claim on Milford Power and that its membership interest was assigned free of charge to Milford Holdings. As the LLC Agreement makes clear, the term "withdrawn member" is defined identically to the term "withdrawing member" in Article 11.9.14 That section provides that a withdrawing member "shall assign all of its rights and interests in the Company to the remaining Members or their designees and the Withdrawing Member waives any and all rights it might have otherwise have had pursuant to the Act arising from its withdrawal from the Company."15 Notably, within thirty days of the withdrawal, Milford Power may terminate any contracts for the provision of goods and services between itself and the withdrawn member and shall have no further liability under those contracts, "other than the payment of any obligations incurred prior to the date of such termination."16 Although the withdrawn member is entitled to indemnification from Milford Power as to any acts of the LLC or its members after the withdrawal, that is the only apparent duty owed to the withdrawn member. The withdrawn member retains, however, the obligation to pay all capital contributions or other debts owed to Milford Power as of the date of the withdrawal and Milford Power is entitled to "retain all contributions theretofore made by the Withdrawing Member...."17

For all these reasons, the plaintiffs say that it is indisputably clear that as of the date PDC filed for bankruptcy, it automatically became a withdrawn member and its membership interest was to be assigned to Milford Holdings free of charge.

III. PDC's Arguments Against Summary Judgment

Unsurprisingly, PDC does not believe that matters are quite so clear-cut. It contends that summary judgment should be denied to the plaintiffs for three primary reasons.

First, PDC argues that the equitable doctrine of unclean hands precludes the plaintiffs from obtaining the relief they seek; that is, PDC seeks to advance an affirmative defense as a barrier to summary judgment. For the reasons previously noted, PDC argues that Milford Holdings and the Lenders have engaged in a course of inequitable conduct designed to deprive PDC of its 5% stake in Milford Power. Because of their oppressive conduct, PDC contends that it had little or no option but to seek protection from the Bankruptcy Court. Thus, because PDC's filing was allegedly caused by the improper conduct of Milford Holdings (or at least by its controlling affiliates, the Lenders), PDC argues that Milford Holdings cannot exploit the bankruptcy filing and use that as a basis to divest PDC of its membership interest.

Second, PDC contends that the Ipso Facto Clause of the LLC Agreement that purports to have made PDC a withdrawn member when it filed for bankruptcy is preempted by federal law. To wit, PDC says that the LLC Agreement is an executory contract and that certain provisions of the Bankruptcy Code preclude the effectiveness of a contract provision divesting a debtor of a property interest in an executory contract simply because the debtor filed for bankruptcy.

Finally, PDC argues that even if the Ipso Facto Clause of the LLC Agreement purporting to make it a withdrawn member is not preempted, that provision does not unambiguously provide for a transfer of PDC's member interest free of charge to Milford Holdings. According to PDC, such an interpretation of the LLC Agreement would render the bankruptcy provision a penalty provision, which is at best disfavored by our law.

I address the first of these two arguments in turn. As will be seen, my resolution of the second issue renders it unnecessary for me to address PDC's third argument.

IV. PDC's Unclean Hands Argument Lacks Merit

PDC's initial argument is that it was somehow forced into a bankruptcy filing by the Lenders and Milford Holdings and that the affirmative defense of unclean hands bars the plaintiff's request for summary judgment. Because its decision to enter bankruptcy was caused by allegedly improper acts of these parties, PDC contends that Milford Holdings cannot rely upon the Ipso Facto Clause.

The problem with PDC's argument is that it is unsupported by any factual contention that makes sense. Contrary to the plaintiffs, I believe it possible to conceive of circumstances in which the improper conduct of a party to an LLC Agreement towards a fellow member could in fact render that member insolvent and cause a valid bankruptcy filing. In that circumstance, the party that acted improperly could be deemed to have forced the bankruptcy filing and therefore be estopped from relying upon that event as a basis to deprive the innocent member of its ownership interest in the LLC. Whether considered unclean hands,18 as PDC would have it, or as a contractual defense precluding Milford Holdings from relying upon the occurrence of a condition its own behavior brought about,19 in the correct circumstances, PDC's argument might be indulged.

This is not an intellectual exercise, however. PDC bears the burden of producing evidence that rationally creates a triable issue of fact regarding the sustainability of its affirmative defense.20 But it has failed to do so, advancing no facts that plausibly support a finding of unclean hands on the part of the plaintiffs. Despite its protestations to the contrary, PDC is well-positioned and duty-bound to support its argument by a non-cursory affidavit. PDC presumably knows exactly what has been done to it.

In none of its submissions has PDC presented any basis to infer that the Lenders did not have every right in law and in equity to collect the massive debt owed to them by Milford Power. Collecting on a lawful debt that is in default is not unfairly predatory; it is a necessary and typical course of action for a lender whose borrower has failed to pay a debt that is due.

In this respect, it is important to note that none of the supposed misconduct to which PDC points is causally related to its bankruptcy filing.21 For example, PDC argues that it was somehow led to believe that the Lenders and Milford Holdings would allow it to continue to hold its 5% interest in Milford Power after El Paso's interest was transferred to Milford Holdings and would receive 5% of the proceeds from any sale of the power plant. That argument is unsupported by any non-conclusory affidavit describing exactly when and how the Lenders and Milford Holdings communicated that supposed agreement to PDC, despite the fact that PDC is obviously well-positioned to make such a description. Nor does the record contain the manifestation one would expect of a representation of that magnitude, namely, a writing of some kind indicating that the Lenders or Milford Holdings was waiving any of their rights under the LLC Agreement or the lending agreements. But even more importantly, whether a representation of that kind was made or not simply could not have caused PDC to file for bankruptcy. The representation, if any, did not make PDC insolvent or even operate to divest PDC of its membership interest.

Likewise, the mere fact that the Lenders had taken steps to foreclose on PDC's membership interest does not, on this record, create a triable issue of fact precluding summary judgment for the plaintiffs. The Lenders had lent Milford Power over $250 million, Milford Power was in default as to approximately that same amount, and PDC's membership interest was pledged as security for that loan. Given these facts, and given the lack of any sensible articulation of a different economic reality by PDC, it is impossible to rationally infer from this record that the Lenders' decision to foreclose could constitute unclean hands.

Most crucially, the Lenders' decision to foreclose did not cause PDC to make a bankruptcy filing. PDC had the option, which it has now taken, to seek to enjoin the foreclosure by filing a lawsuit in state court. Instead, it made the tactical decision to file a bankruptcy petition that the Bankruptcy Court found to be improvident. That PDC no doubt did so precisely to forestall the foreclosure sale does not, however, mean that the Lenders' actions rendered PDC insolvent and therefore caused the bankruptcy filing. The decision to file for bankruptcy was PDC's own tactical choice and there is no evidence that creditors other than the Lenders were beating on its door.

Likewise, PDC's assertion that Milford Holdings has been making decisions for Milford Power without including PDC in the process does not preclude summary judgment. Regardless of whether or not that has occurred and whether or not that was improper if it did occur, Milford Holdings' actions did not cause PDC to file for bankruptcy. If PDC believed that its rights as a member of Milford Power were being violated, it could, and later did, file a lawsuit. But, there is no evidence that those violations rendered PDC insolvent or caused it to file for bankruptcy.

In sum, there is no evidence in this record that would justify a rational inference that the Lenders did not have a good faith basis to attempt to foreclose on PDC's interest in Milford Power. The cursory and confusing contentions made by PDC regarding the supposedly improper conduct towards it do not cohere into any rationally explicable economic scenario involving inequitable or illegal conduct by the Lenders and Milford Holdings. At best, one infers that PDC believed that it possessed some ability to extract consideration from the Lenders as a price for supporting the transfer from El Paso to Milford Holdings and thought that it had done just that by receiving unspecified representations (from someone unspecified on some unspecified date) that PDC would continue to own 5% of Milford Power, regardless of whether the Lenders had been repaid in full. An unusual belief of this kind would seem to be precisely the kind that would normally be embodied in a writing, and none is in the record. Nonetheless, what remains most critical is that none of the supposed misbehavior by the Lenders or Milford Holdings caused PDC to make a bankruptcy filing.

In so concluding, I do not hesitate to surface some normative assumptions that support the result I reach. For starters, the unclean hands doctrine should always be applied with prudence and not as a wide-ranging license for judges to constrain parties that are alleged to have engaged in conduct that might be perceived as harsh or unfair, but that is nonetheless not a breach of any precise legal or equitable duty.22 Many sophisticated parties like PDC sign contracts that have terms that might be considered onerous; our law does not relieve them of the burden of those decisions simply because of their after-the-fact regrets. To do so would greatly undermine the utility of contracts, to the detriment of wealth creation.23

To adopt PDC's argument would invite debtors to resort inappropriately to the Bankruptcy Courts in situations when there are other legal processes open to them to protect their rights. Rather than pursue the appropriate course of action and attempt to enjoin the procession of a foreclosure sale in the expected manner — through an action in a state court with jurisdiction — debtors will simply make Bankruptcy Court filings. Even if, as here, that Bankruptcy Court filing is later dismissed as unwarranted, the debtor has bought time because of the automatic stay provision, thus forestalling the foreclosure sale through the simple expedient of making an unjustified filing. Even better, from the debtor's perspective, is that the improvident filing comes almost cost-free because the debtor would have license to argue that the doctrine of unclean hands precludes the enforcement of contractual rights belonging to the lender or its affiliates that are triggered by a bankruptcy filing unless and until it is definitively determined that the lender and its affiliates did not violate any legal or equitable rights of the debtor, regardless of whether the debtor was actually rendered insolvent by the lender and its affiliates before the bankruptcy filing.

There is no justification for creating a perverse incentive scheme of this kind in the name of equity. If a debtor believes that a lender is improperly foreclosing on its interests, it is, of course, free to seek to enjoin the foreclosure or to file for other relief. But if, instead, it chooses to file a bankruptcy application, the debtor is in no position to demand that a court of equity to relieve it of the consequences of that tactic when the tactic fails because the Bankruptcy Court concludes that the filing was unsustainable. That is especially so when the debtor cannot articulate any rational basis for the court to make a rational inference that the Lenders were not acting in the good faith belief that they had a right to foreclose.

For all these reasons, I conclude that the doctrine of unclean hands does not prevent the entry of summary judgment for the plaintiffs. If PDC's claims of improper conduct by the Lenders are later upheld by a New York court, PDC can be made whole by an award of monetary damages.24 In the meanwhile, there is no rational justification in equity or law for preventing Milford Holdings from exercising its clear contractual rights.

V. Is the Ipso Facto Provision In The LLC Agreement Preempted By Federal Law?

PDC's next argument requires a consideration of provisions of the Bankruptcy Code that have generated conflicting and confusing decisions from federal courts. Thousands of pages of judicial, lawyerly, and academic writings on the subject have tried to instill some predictability and coherence into the aspects of bankruptcy law relevant to this decision but no consensus has resulted,25 leaving conflicting precedent.

The courts of this state have no power to clear these murky waters and I will not burden the reader with a recitation of the full debate relevant to the decision I must make. Instead, I will endeavor to describe the parties' contending positions and to render a sensible, if by no means inarguable, decision.

I begin by describing PDC's argument. PDC contends that its membership interest in the LLC Agreement became part of the Bankruptcy Estate when it filed for bankruptcy on February 27, 2004, irrespective of the Ipso Facto Clause. In support of that argument, PDC points initially to § 541(c)(1) of the Bankruptcy Code, which states in pertinent part that:

By virtue of § 541(c)(1), PDC says that its membership interest vested in the estate when its bankruptcy case was commenced. Moreover, because of the nature of PDC's membership interest, PDC argues that another section of the Bankruptcy Code is implicated. To wit, PDC contends that the LLC Agreement is an executory contract within the meaning and reach of § 365(e)(1) of the Bankruptcy Code, which states in pertinent part that:

In contending that the LLC Agreement is an executory contract, PDC is able to draw on the substantial weight of federal authority which treats agreements for the operation of entities like limited partnerships and LLCs as executory contracts when those agreements contemplate an important, on-going role for the debtor in management.28 For purposes of their motion for summary judgment, the plaintiffs have elected to assume that the LLC Agreement is an executory contract and I therefore consider that concession to settle the question.29

According to PDC, § 365(e)(1) embodies Congress's intent that ipso facto clauses like the one in the LLC Agreement be preempted. That is especially so, says PDC, because § 349 of the Bankruptcy Code states:

PDC argues that when taken together, §§ 365(e)(1) and 349 establish that its bankruptcy filing must be deemed a non-event and that PDC's membership interest in Milford Power must be the same as it had been before the bankruptcy filing. That is, PDC contends that §§ 365(e)(1) and 349 represent a clear statement by Congress that contractual provisions like the Ipso Facto Clause and statutory provisions such as § 18-304(1)(b) of the Delaware LLC Act are preempted. The public policy that supports this preemption, PDC contends, is the desire to ensure that valuable assets of a bankrupt are preserved and can be deployed by the bankrupt estate to meet the claims of creditors. Thus, PDC submits that because the Bankruptcy Court took no action to deprive PDC of its membership interest during the pendency of PDC's Bankruptcy case, that membership interest remained undisturbed and revests in PDC, free and clear from any effect of its bankruptcy filing.

PDC's argument is a colorable one. There is federal precedent that holds that an interest in an alternative entity — even a managing interest in a limited partnership — falls within the protective scope of § 365(e)(1) and that an ipso facto clause may not operate to divest a bankruptcy trustee from assuming that contract.31 There is also precedent from other states that indicates that § 365(e)(1) and § 349 preclude the enforcement of an ipso facto clause by a creditor even when the debtor's bankruptcy case has been dismissed and no express order of the Bankruptcy Court precludes enforcement of the clause.32 That is, this precedent holds that the Bankruptcy Code does not just forestall the enforcement of an ipso facto clause while the debtor is in bankruptcy or when there is a Bankruptcy Court order to that effect but instead operates as an absolute bar to the enforcement of a contract or statutory provision that divests a debtor of an interest in an executory contract simply because the debtor filed for bankruptcy.

As straightforward as PDC's argument might appear at first blush, there is other legal authority that cuts against PDC's argument for preemption. For example, § 365(e)(1) does not apply in certain circumstances to executory contracts, to wit:

Another subsection of § 365 also touches on this issue, and states in key part that:

These sections, taken together, bear on this case because they express a federal policy limitation on the Bankruptcy Code's invalidation of ipso facto clauses. In essence, § 365(e)(2) and § 365(c)(1) (taken together, the "Assumability Exceptions") are an expression of Congress's recognition that certain types of executory contracts to which debtors are parties (e.g., personal services contracts) should not be assumable by a Bankruptcy Trustee in circumstances when state law would not require the non-debtor parties to accept substitute performance. In the case of an LP or LLC agreement that makes the debtor-partner or member a key part of the entity's management on a going-forward basis, there is, as we shall see, a strong argument that these sections preclude a Bankruptcy Trustee from assuming at least those aspects of the contract granting the debtor managerial rights even if the Trustee is the debtor in possession — i.e., when the debtor itself is in charge of the bankrupt estate.

The plaintiffs have chosen not to dilate on the ramifications of the Assumability Exceptions to the Bankruptcy Code's anti-ipso facto clause provisions, preferring to rely upon a strand of state law authority. This authority comes from state courts that have addressed the question of what effect §§ 541, 365, and 349 of the Bankruptcy Code have on the enforceability of contractual ipso facto clauses against a debtor whose bankruptcy filing is dismissed without any order of the bankruptcy court addressing whether the clause can be enforced after the dismissal.

In Miller v. Parlor Furniture of Hickory, Inc., a lease contained an ipso facto clause triggered by the filing of a bankruptcy petition. The debtor's bankruptcy case was dismissed and the lessor sought to terminate the lease in reliance upon the ipso facto clause. The North Carolina Court of Appeals held that the lessor could terminate, stating:

Miller is important, here, say the plaintiffs, because its reasoning was relied upon by our Superior Court in Chrysler Financial Corp. v. Fruit of the Loom, Inc.36 In that case, the court decided that a lessee that had consented to an involuntary bankruptcy filing had defaulted on a lease governed by Texas law because that filing triggered the lease's ipso facto clause. Because the lessee's bankruptcy case was dismissed and the lessee was no longer under the protection of the bankruptcy court, Judge Bifferato justified his conclusion thusly:

Earlier in his opinion, Judge Bifferato cited to legislative history regarding § 365, which he read as supporting the result he reached. That history indicates that § 365(e)(1) "does not limit the application of an ipso facto or bankruptcy clause if a new insolvency or receivership occurs after the bankruptcy is closed. That is, the clause is not invalidated in toto, but merely made inapplicable during the case for the purposes of disposition of the ... unexpired lease."38

The plaintiffs argue that I can simply follow the teaching of Chrysler Financial and ignore the Bankruptcy Code altogether, as being completely irrelevant to this case. As I am not convinced that this is so, I will outline the alternative rationale that, in my view, better justifies the entry of (an albeit more limited) summary judgment order for the plaintiffs. That rationale is grounded in the Assumability Exceptions.

Arguably, the Delaware LLC Act excuses Milford Holdings from accepting performance from a trustee or assignee. For one thing, § 18-304 represents a default rule of Delaware public policy that expresses the view that, absent a contractual provision to the contrary, members of a Delaware LLC need not fear that they will have as fellow members bankruptcy trustees or assigns of bankruptcy trustees. That is, § 18-304 expressly recognizes the unique relationships that exist among members of LLCs and protects solvent members from being forced into relationships they did not choose that result from the bankruptcy of one of their chosen co-investors. Likewise, other provisions of the LLC Act that provide that assignees of membership interests be denied any right to participate as a member in the governance of the entity, absent a provision in an LLC agreement to the contrary39 also constitute applicable law that excuses a solvent member from accepting substitute performance as a member from a Bankruptcy Trustee or an assignee of a Bankruptcy Trustee.

There are, of course, sound economic reasons why Delaware law, like that of many other states, embraces a default rule that terminates an LLC member's interest upon a bankruptcy filing. Typically, LLCs are closely held and the members often have important managerial duties and powerful voting rights. The Milford Power LLC Agreement is no exception; PDC's 5% interest gave it a seat on every important management committee and voting rights that enabled it to veto a range of significant business transactions. In a lucid article, Professor Ribstein has persuasively explained the rational reasons why investors in alternative entities would agree in advance to forsake their ownership interest upon filing bankruptcy because, by doing so, they insulate themselves from the economic harm that might result to them if one of their co-venturers files for bankruptcy.40 The harms than can result include having a co-venturer with important power over the entity, whose economic incentives are distorted by its insolvency, push to liquidate the venture or to take other short-term measures that are beneficial to it as a debtor but detrimental to the venture as a whole and its other investors.41 Notably, Professor Ribstein also points out that investors are free to structure LLC agreements that do not divest members of their interests upon bankruptcy and that creditors are well-positioned to protect themselves in their dealing with investors in LLCs through contract.42 For these and other reasons, Professor Ribstein contends that the confusing and ambiguous language in § 365(e)(1) should not be construed as preempting ipso facto clauses in limited partnership agreements, and it is fair to say that his arguments as to limited partnerships apply with full force to LLCs.

At the same time, thoughtful commentators hold views in stark contrast to Professor Ribstein's. For example, the National Bankruptcy Reform Commission, which was established by Congress, recommended that "[i]pso facto provisions relating to partnerships, LLCs, and the rights or interests of partners or LLC members should not be enforceable under the Bankruptcy Code."43 The Commission's recommendations to clarify this aspect of federal law were not adopted. Its recommendations, however, are echoed in the holdings of several federal court decisions. At a bare minimum, the Commission's view rests on the not-insensible notion that a debtor ought not be deprived of a valuable interest simply because it has made a bankruptcy filing, especially if that interest is a purely economic interest in the relevant alternative entity.

As I have noted, the federal case law interpreting § 365 of the Bankruptcy Code is confusing and in conflict, leaving the questions of whether, and to what extent, ipso facto clauses in alternative entity agreements are preempted less than clearly answered. Some federal courts, such as the United States Court of Appeals for the First Circuit, have read § 365(e)(1)'s invalidation of ipso facto clauses broadly and the Assumability Exceptions narrowly, even in the context of addressing the assumability of a managing interest in an alternative entity.44 On the other hand, several federal courts have issued decisions that interpret the Bankruptcy Code in a manner more sympathetic to Professor Ribstein's position and more in keeping with Delaware public policy. These decisions have read the Assumability Exceptions in a literal manner, construing them as plainly stating that "a debtor in possession may not assume an executory contract over the nondebtor's objection if applicable law would bar assignment to a hypothetical third party, even where the debtor in possession has no intention of assigning the contract in question to any such third party."45 These holdings have read the plain words of the Assumability Exceptions as representing a congressional intent to respect the contract rights of parties when applicable law provides that the parties do not have to accept substitute performance from a third-party without their consent. Notably, the United States Court of Appeals for the Third Circuit and the federal Bankruptcy Court in Delaware adhere to this literal approach.46

A law professor could fruitfully spend the next year or so examining the implications that the Bankruptcy Code has on ipso facto clauses in alternative entity agreements. As a state trial judge with many cases to decide, I do not have all year to peer through the muck in search of what will at most be a debatable answer. Rather, I must decide promptly whether the clear law of my state is preempted by federal law.

Although state trial judges are duty-bound to respect the supremacy of federal law within its expansive sphere and to respect congressional decisions to preempt our law, we are not duty-bound to go out of our way to look for reasons to preempt our own state's law. Nonetheless, the question of whether the Bankruptcy Code preempts the application of the Ipso Facto Clause in the LLC Agreement requires this court to apply with fidelity the preemption principles articulated by the federal courts. Fortunately, the federal courts have been restrained about finding that the Bankruptcy Code's terms preempt state law provisions generally governing the property rights of bankrupt debtors. Although Congress clearly has the power to establish uniform bankruptcy laws throughout the United States, "Congress has [also] generally left the determination of property rights in the assets of a bankrupt's estate to state law."47 Therefore, in examining whether the Bankruptcy Code preempts state law, the United States Court of Appeals for the Third Circuit has held that the "usual rule is that congressional intent to pre-empt will not be inferred lightly. Pre-emption must be either explicit, or compelled due to an unavoidable conflict between the state law and the federal law."48

In keeping with that teaching, I apply a restrained preemption analysis in this case and do not reach out to imagine or exaggerate conflicts between Delaware law and the Bankruptcy Code. On the other hand, I am also duty-bound not to ignore an "explicit" congressional preemption of state law or an "unavoidable conflict" between the Bankruptcy Code and Delaware law.49

Cutting to the chase, I do perceive § 18-304 of the Delaware LLC Act (and therefore the Ipso Facto Clause in the Milford Power LLC Agreement) to be preempted to some limited extent. In so ruling, I acknowledge that under the reasoning of Chrysler Financial Corporation, the Superior Court found that §§ 365 and 541 of the Bankruptcy Code only operate to defang ipso facto clauses while the debtor is actually in Bankruptcy Court and that the federal government has no interest in protecting debtors whose bankruptcy filings are dismissed without a Bankruptcy Court order protecting their interest in executory contracts containing ipso facto clauses.

The problem with that argument, from my perspective, is that it slights the obvious purpose of the Bankruptcy Code in precluding ipso facto clauses from working forfeitures of important economic assets of debtors. Section 349 of the Bankruptcy Code has been construed as extending that protection to a debtor whose case is dismissed. In First Sec. Bank v. Creech, the Utah Supreme Court held that, irrespective of a default under an ipso facto clause, debtors whose bankruptcy filing had been dismissed had their interests in the relevant contract restored under § 349 as if the bankruptcy filing had never occurred.50 In keeping with Creech, Professor Erlich has expressed the view that:

The plaintiffs argue that § 349 simply means that the debtor gets back the property interest it possessed immediately before the bankruptcy filing but does not mean that the effect of the bankruptcy filing under state law is preempted. Although Congress gave debtors in the Bankruptcy Courts protection against ipso facto clauses, they noted that § 349 does not explicitly indicate that the anti-ipso facto clause provisions of the Bankruptcy Code continue to preclude enforcement of an ipso facto clause after a dismissal and that there is legislative history that suggests that those provisions only stay enforcement of the ipso facto clause until the Bankruptcy case concludes or unless the Bankruptcy Court expressly overrides the ipso facto clause and vests the property in the estate or a transferee of the estate, free and clear of the clause's operation.52

The problem I have with the plaintiffs' argument is that it suggests that Congress's antipathy towards ipso facto clauses was capriciously implemented. So long as a debtor remains in bankruptcy, the Bankruptcy Code neutralizes the effect of an ipso facto clause, thereby enabling the debtor's estate to use the asset subject to forfeiture to satisfy creditor claims. But if a debtor's bankruptcy case is dismissed, the debtor may be stripped of an important economic asset by virtue of the mere fact of filing for bankruptcy without restriction by the combined operation of §§ 365, 541, and 349 — a stripping that might in turn lead to the actual insolvency of the debtor. Although the plaintiffs contend that Congress was implicitly exacting a toll on improvident bankruptcy filings by permitting ipso facto clauses to be enforced after a dismissal, they cite no legislative history suggesting such an intent and there are other aspects of bankruptcy law that serve that purpose expressly.53 In view of the evident hostility towards ipso facto clauses in §§ 365 and 541, and the language of § 349, I conclude that Congress intended that a debtor whose bankruptcy filing was dismissed should not, when its property interests revest under § 349, be subject to any greater consequences from the operation of an ipso facto clause than it would have been had the relevant contract at issue been addressed within the context of a plan approved by the Bankruptcy Court itself.

As a consequence, I reach a result in this case that is different from either that advocated by PDC or by the plaintiffs. For PDC's part, it wishes me to conclude that the Bankruptcy Code entirely preempts the application of the Ipso Facto Clause and § 18-304 of the Delaware LLC Act. For the plaintiffs' part, they wish me to conclude that the Bankruptcy Code has no preemptive effect at all on the Ipso Facto Clause or § 18-304.

I reach the more nuanced conclusion that an ipso facto clause in an LLC contract retains the same potency after a § 349 dismissal that it would have during the course of a bankruptcy proceeding. In so holding, I reject in an important measure the argument made by PDC. Under PDC's view, a debtor receiving a § 349 dismissal would be in a better position to avoid the effects of an ipso facto clause than a debtor whose bankruptcy filing was not dismissed. To understand what I mean, it is critical to consider the effect of the Assumability Exceptions. Read literally, the Assumability Exceptions expressly state that a bankruptcy estate may not assume an executory contract over the non-debtor's objection if state law would bar assignment of that contract to a hypothetical third party. Being under no duty to search for reasons to conclude that Congress has preempted Delaware law, I approach the relevance of the Assumability Exceptions by accepting the literal interpretation of that section adopted by the United States Court of Appeals for the Third Circuit and several other federal courts of appeal.54 Under that interpretation, the Assumability Exceptions preclude even a debtor in possession in bankruptcy from accepting an executory contract if state law would preclude assignment of that contract to a hypothetical third party.

Applying this literal approach, the question then becomes whether the Delaware LLC Act excuses the members of Milford Power from accepting performance from an assignee of PDC's membership interest. Put more broadly, does the Delaware LLC Act excuse members of a limited liability company from accepting performance of an LLC agreement from an assignee of another member? Although one would not know it from reading the parties' briefs, this precise question was recently addressed by Judge Farnan of the United States District Court for the District of Delaware in the case of In re: IT Group, Inc.55 In that case, two debtor-members of a Delaware LLC attempted to assign their membership interests to a third party. Another member of the LLC, Northrop, objected to the attempted assignment. It argued that the Delaware LLC Act did not require Northrop to accept performance from the debtor-members' assignee and that the ipso facto clause in the relevant LLC agreement was enforceable. In the alternative, Northrop argued that the Delaware LLC Act precluded the debtor-members from assigning anything other than the rights specified in § 18-702(b)(2) of the Delaware LLC Act, which accords an assignee the right to participate in profits and losses of a limited liability company. Moreover, Northrop contended that a provision of the LLC agreement giving members a right of first refusal as to the transfer of any other member's interest was enforceable.

On appeal from the Bankruptcy Court, Judge Farnan held that the Bankruptcy Court was correct in rejecting Northrop's primary argument and embracing its alternative argument.

The Bankruptcy Court held that the debtor-members were barred from transferring their full membership interests because Delaware law excused Northrop from accepting substitute performance. In other words, the Assumability Exceptions operated to exempt the ipso facto clause's force from § 365(e)(1) and to permit the ipso facto clause to deprive the debtor-members of their non-economic rights as members. By contrast, however, the Bankruptcy Court held that the debtor-members could assign their economic interests in the profits and losses of the limited liability company because Delaware law did not excuse Northrop from accepting assignment of these "bare economic rights." To that extent, the ipso facto clause was invalidated by § 365(e)(1) and the debtor-members retained their ongoing right to profits and losses, and could transfer that interest. In so holding, the Bankruptcy Court rejected Northrop's argument that the debtors were "either in default ... or [were] not" under the ipso facto clause and that there was no reason to treat the economic rights of the debtor differently from the rights of the debtor to participate as a full member.56

On appeal, Judge Farnan affirmed, stating:

Judge Farnan also upheld the Bankruptcy Court's determination that the debtor-members' right to transfer their bare economic rights was subject to Northrop's right of first refusal. Because the right of refusal existed as to any transfer, whether the transferor was in bankruptcy or not, that property right was to be respected within the bankruptcy process and would not, he reasoned, injure the debtor-members' ability to recoup the full value of their bare economic rights.58

Applying the reasoning of Judge Farnan here leads to the conclusion that the Ipso Facto Clause in the Milford Power LLC Agreement is effective to the extent that it deprived PDC of its ability to participate as a member in the governance of Milford Power. Under the Delaware LLC Act, other members of Milford Power are — as a matter of default law — excused from accepting substitute performance of governance rights and duties and therefore the participatory rights of PDC fall outside the reach of § 365(e)(1)'s invalidation of ipso facto clauses. By contrast, under the Delaware LLC Act, the other members of Milford Power are not excused — again, as a matter of default law — from accepting an assignment of PDC's bare economic rights as an equity owner. Thus, after the dismissal of its bankruptcy filing, PDC possessed the same rights as an assignee under § 18-702(b)(2).59

Judge Farnan's reasoning balances the competing policy interests at stake. In keeping with § 18-702(b)(3) (and even § 18-304) of the Delaware LLC Act, his ruling respects the default law of this state by refusing to permit a debtor to transfer its right to participate "in the management of the business and affairs" and "exercise any [governance] rights or power of a member" in an LLC absent specific contractual authorization.60 At the same time, however, he noted that the General Assembly had concluded that the economic rights of a member in an LLC were, as a general matter, freely assignable. In other words, he concluded that Delaware's default law specifically distinguished between those aspects of an LLC Agreement that should not be freely transferable because substitute performance should not be imposed on the other members absent their express consent (i.e., the managerial powers and duties) and those aspects that should be freely transferable (i.e., the passive right to share in profits and losses). This distinction, like those made by federal law, recognizes that it is far more tolerable to have to suffer a new passive co-investor one did not choose than to endure a new co-manager without consent. The same logic applies when a member of an LLC must remain in a relationship with a member that has filed for bankruptcy. By terminating the bankrupt filer's status as a member with governance rights, the solvent members only have to live with the bankrupt filer as an assignee with a passive economic interest.

Notably, this distinction is also reflected in the Milford Power LLC Agreement itself. In Article 9.5, the LLC Agreement recognizes that there might be circumstances when the company is required to recognize a transfer that has been accomplished in violation of the procedures of the LLC Agreement itself, e.g., in violation of the first refusal rights granted to other members by Article 9.2. In the circumstance when "the Company is required to recognize such disposition or transfer, the Units so transferred shall be strictly limited to the transferor's rights to allocations and distributions as provided by this Agreement with respect to the transferred Units...." Furthermore, as a general matter, the Milford Power LLC Agreement recognizes that members may have a need to transfer their units, and provides procedures by which transfers may be accomplished. Although the other members must in most situations provide "prior written consent" to a transfer, that consent "cannot be reasonably withheld, conditioned, or delayed."61

Of course, I recognize that a reasonable mind could conclude that the outcome I reach is neither incontestably required by the applicable law nor economically optimal. One can argue, as Professor Ribstein, does that state courts should treat the Bankruptcy Code as non-preemptive of ipso facto clauses in non-bankruptcy cases involving limited partnerships and limited liability companies until Congress makes its intent to preempt indisputable. By vindicating the contractual expectations of venturers, he would say, we best promote responsible wealth creation. I respect that view, as it accords with the public policy of my state as expressed in § 18-304 of the Delaware LLC Act. His view, which was that adopted in Chrysler Financial, also has the virtue of being clear: outside of bankruptcy, ipso facto clauses are always enforceable absent a prior federal court order to the contrary.

On the other hand, the position of PDC also has the same virtue of simplicity. If the Bankruptcy Code is read as erasing the effect of a bankruptcy filing upon a § 349 dismissal, then members of limited partnership or LLCs simply have to live with having as a fellow member a person or entity that filed for bankruptcy and had their case dismissed. If the evident intent of Congress is to avoid having the simple fact of a bankruptcy filing work a forfeiture on a debtor's property interests, then state courts should respect that intent and not penalize a debtor whose bankruptcy case is dismissed by subjecting them to a loss of property that they would not have suffered at the hands of a bankruptcy court had their case not been dismissed.

By adhering to the reasoning of Judge Farnan in the In re: IT case, I leave the parties with a more complex outcome. By enforcing the Ipso Facto Clause so as to deprive PDC (or a transferee from it) of the ability to exercise the strong participatory rights given to PDC by the LLC Agreement, I recognize the legitimate business justification for § 18-304 and ipso facto clauses modeled on it, a justification well-explained by Professor Ribstein's article on the subject. At the very least, my approach alleviates the concern that members will, because of solvency concerns, interfere with the ability of a limited liability company to pursue risky business strategies that hold the promise for large profits.

But, by recognizing what I perceive to be the preemptive force of the Bankruptcy Code on ipso facto clauses to the extent that they deprive an LLC member of the economic rights set forth in § 18-702(b)(2), I also respect Congress's desire to avoid having property interests of debtors divested simply because the debtors filed for bankruptcy. This desire is not entirely alien to our law, as our courts have often noted that Delaware law does not favor interpretations that result in forfeitures.62

That is, the practical effect of my ruling leaves § 18-304 with continued vitality. Essentially, as I have read it, § 18-304 means that a member who files for bankruptcy still ceases to be a member, but becomes an assignee with the economic rights specified in § 18-702(b).

Because I have concluded that the Ipso Facto Clause cannot be applied to deprive PDC of the economic rights of an assignee,63 I need not determine whether, as the plaintiffs contend, PDC — as a withdrawn member — would have been deprived entirely of its interest in the profits and losses of Milford Power. Although that appears to be the only sensible reading of the LLC Agreement,64 I need not and do not rest my conclusion on that ground.

Notably, because I have held that PDC continues to possess the economic rights of an assignee in Milford Power, its argument that the doctrine of unclean hands should bar the plaintiffs' claim is further enervated, as nothing in this ruling will deprive PDC of the right to share in the proceeds of any sale of the power plant. Rather, PDC will be deprived of that opportunity only if the Lenders are successful in their foreclosure action or for other circumstances that would not flow directly from this decision.

VI. Conclusion

For all these reasons, the plaintiffs' motion for summary judgment is granted in part. PDC has been divested of its right to participate in the management of Milford Power and only retains the economic rights of a transferee under § 18-702(b)(2). The plaintiffs shall prepare a conforming final order and submit it to me, upon notice to PDC as to form, within twenty days. Each side shall bear its own costs.