Operating Agreement Provisions Setting Limits on the Authority of Members or Managers to File a Bankruptcy Case Are Generally Enforced
Notwithstanding the foregoing, operating agreement provisions that set limits on the authority of members or managers of a limited liability company to file a bankruptcy case are generally enforced. Courts enforcing such provisions make a distinction between waivers of the right to file bankruptcy, and members voluntarily agreeing among themselves that authority to file a bankruptcy shall not exist absent satisfaction of certain conditions precedent.
State law determines who has the legal right to sign and file a bankruptcy petition on behalf of an entity. In fact, the U.S. Supreme Court has determined that “[t]he authority to file a bankruptcy petition must be found in the corporation’s instruments and in applicable state law.” As such, courts have held that a bankruptcy case filed on behalf of an entity by one without requisite authority under state law is improper and must be dismissed for, among other reasons, lack of jurisdiction.
State limited liability company statutes generally do not expressly prescribe whether members or managers have the power to file a bankruptcy petition. As such, the authority determination almost always requires an analysis of the terms of the limited liability company’s operating agreement. Limited liability companies are “primarily creatures of contract.”Therefore, great deference is given to provisions contained in operating agreements and other governing documents agreed upon by the members.
Given this great deference, it has been determined that “the long-standing policy against contracting away bankruptcy benefits is not necessarily controlling when what defeats the rights in question is a corporate control document.” Provisions in limited liability company operating agreements that require certain approvals or unanimous consent by managers or members before filing a bankruptcy petition are frequently enforced. For example, in In re Avalon Hotel Partners, LLC, the limited liability company operating agreement required 75-percent member approval for certain “major decisions.” Although bankruptcy was not specifically listed as an event triggering the “major decision” clause, the bankruptcy court easily reached the conclusion that a bankruptcy filing fell within the scope of that provision and, thus, imposed the 75-percent requirement.
When the contractual provision at issue gives lenders an explicit voice in the filing of a bankruptcy petition, the analysis becomes far more complex. Nevertheless, as highlighted by the two cases discussed below, where a lender is acting in its capacity as a member, as opposed to a creditor, such provisions may well be enforced.
In re Global Ship Systems, LLC. In In re Global Ship Systems, the debtor’s operating agreement established a lender as a “Class B Shareholder.” The Class B Shareholder interest consisted of approximately 20 percent of the equity of the company. The debtor’s operating agreement provided that the filing of a voluntary bankruptcy by the limited liability company required the consent of the Class B Shareholder. The lender would not consent to a filing. Therefore, in order to avoid the consent requirement under the operating agreement, the debtor solicited the filing of an involuntary bankruptcy case that it then failed to contest.
The court concluded that the end-run around the lender’s contractual rights as a member was inappropriate and dismissed the case. The court noted: “The fact is that the petitioning creditors’ participation in this case was solicited by the Debtor which was prohibited by the Operating Agreement from filing a voluntary case without [lender’s] consent." Further noting that the lender was both a creditor and an equity holder, the court found that the lender:
Was granted certain protections in the governance of the LLC. [The debtor] could not sell substantially all of its assets, merge with another company, or file a voluntary bankruptcy case without the consent of [lender]. An absolute waiver of the right to file bankruptcy is violative of public policy if asserted by a lender. However, since [the lender] wears two hats in this case, as a Class B shareholder, it has the unquestioned right to prevent, by withholding consent, a voluntary bankruptcy case.”
Citing various provisions of the Georgia limited liability company statute, the court found that state law permits “to the maximum extent possible, parties to exercise freedom of contract in the structuring of LLCs.” To accord state law’s legislative determination that limited liability companies “should be granted extremely broad discretion in the organization and management of their affairs,” the court concluded that the lender retained a separate, enforceable right, as an equity holder, to refuse to consent to the filing of a voluntary bankruptcy case. Given that the involuntary case was commenced in violation of such right, and in light of other facts unfavorable to the debtor, the case was dismissed as being filed in bad faith.
In re DB Capital Holdings, LLC. In In re DB Capital Holdings, the debtor was a manager-managed limited liability company that was created to develop and sell a luxury condominium project in Aspen, Colorado. The debtor had two members, Aspen and DB Development. The manager had no ownership interest in the debtor but was an affiliate of DB Development.
Under the operating agreement, the rights and powers given to the manager pertained only to managing the affairs of the debtor in the ordinary course of business. The members of the debtor subsequently attempted to strip the company of its ability to file a bankruptcy petition by amending its operating agreement to include a provision that the company: “will not institute proceedings to be adjudicated bankrupt or insolvent; or consent to the institution of bankruptcy or insolvency proceedings against it; or file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy.”
A few years later, the manager of the debtor filed a voluntary bankruptcy petition on the debtor’s behalf for purposes of defeating a state court receivership commenced by the debtor’s mortgage lender. Aspen did not consent to the filing and sought to dismiss it as unauthorized based on the provision in the debtor’s operating agreement. The manager argued that such a provision should be invalidated on public-policy grounds because the provision was included at the lender’s behest. The bankruptcy court disagreed and dismissed the case.
The Tenth Circuit affirmed on appeal, concluding that the express terms of the operating agreement could prohibit the limited liability from seeking bankruptcy relief. The court rejected the manager’s argument that the antibankruptcy provisions in the operating agreement were void as a matter of public policy, noting that he had not cited any support for the proposition that members of a limited liability company cannot agree among themselves not to file bankruptcy. The court declined to address the manager’s argument that the provision was a product of coercion by the debtor’s secured creditor, and therefore unenforceable, because the evidentiary record did not support such an allegation.
Finally, the court concluded that even if it had disregarded the express prohibition against a bankruptcy filing, such a filing on behalf of the limited liability company was outside the scope of the manager’s authorized duties as set forth in the operating agreement. Under the operating agreement, the manager was only authorized to operate the debtor in the ordinary course of business. The filing of a chapter 11 proceeding, the court found, “represents a radical departure from how any entity carries on its business outside of bankruptcy.” Accordingly, because the members were entitled to, and in fact did, agree among themselves to preclude the manager from filing bankruptcy, and because there was no evidence that such provision was inserted at the insistence of the lender, the appellate panel held that the filing was unauthorized, and therefore affirmed the bankruptcy court’s decision to dismiss the case.
All of the cases discussed above begin with the general premise that waiving or contracting away the right to file for relief under the Bankruptcy Code is contrary to public policy. Nevertheless, as the case law has developed over the years, a number of courts have held that operating agreement provisions that set limits on the authority of members or managers of a limited liability company to file a bankruptcy case are enforceable. The secured lending community has taken note of this, and creative lenders in recent years have structured or characterized their loan transactions to include an equity component, which arguably would give them the power to control its borrower’s fate with respect to its ability to commence a bankruptcy case. Part two of this article will address how courts have dealt with these extremely difficult cases.