Contributed by Joshua Nemser
“How can we be expected to teach children to learn how to read… if they can’t even fit inside the building?”
– Derek Zoolander
Zoolander was on to something. How can we worry about bankruptcy law if an entity is not authorized to file a bankruptcy petition in the first place? In In re Solomons One, LLC, the United States Bankruptcy Court for the District of Maryland interpreted an LLC’s operating agreement to resolve a dispute of whether majority vote or unanimous consent was required to authorize a bankruptcy filing. We have covered this topic before. The takeaway? Draft carefully and thoughtfully. The court’s holding in Solomons One was almost entirely based on the operating agreement itself, and so the case reinforces that corporate governance documents should be written such that parties can have reasonable certainty ex ante as to what it takes to get into—or stay out of—bankruptcy court.
Solomons One, LLC was formed in 2005 under the laws of the State of Maryland. The LLC was formed to acquire, purchase, lease, sell and develop certain waterfront commercial real property located in Solomons, Maryland. As is typical, the members of the LLC executed an operating agreement to memorialize their understanding regarding the company’s conduct and affairs.
The LLC acquired the real property, known as the “Harmon House,” in August, 2005. Following its acquisition of Harmon House, the LLC became obligated under two bank loans, both of which are secured by the property. By February, 2013, the loans were in default. The first lienholder, BB&T, began a state court proceeding to “liquidate its obligation.” A hearing on the state court proceeding was scheduled for August 23, 2013. Two days before the hearing, the members of the LLC met to discuss whether a bankruptcy petition should be filed in order to stay that hearing. Members representing 51 2/3% of the membership interests voted in favor of the filing, and shortly thereafter, the LLC filed for protection under chapter 11 of the Bankruptcy Code.
The dissenting members filed a motion to dismiss the bankruptcy case. They alleged that the operating agreement is silent as to the requisite consent required to authorize a bankruptcy filing, and as a result, Maryland law requires unanimous consent of the members to do so.
The Operating Agreement
The dissenting members’ assertions were technically correct: the operating agreement does not contain an explicit provision addressing the requisite approval for a bankruptcy filing. What this case demonstrates, however, is that courts may infer the requisite approval from a review of the operating agreement in its entirety.
The court established that an operating agreement is a binding contract, and accordingly, looked to prevailing contract law. Under “the law of objective contract interpretation,” the court concluded that “a reasonable person could only understand [the operating agreement] as requiring the consent of the majority of the member interests to authorize the filing of a bankruptcy petition.”
In reaching its conclusion, the court reviewed every section of the operating agreement and noted which corporate actions require a majority vote and which require unanimous consent. Under the operating agreement, “both ordinary course and extraordinary transactions” can be accomplished by majority vote. For example, the agreement provides that the LLC can encumber or sell “any or all of” the real property, its only asset, with a majority vote of the members. The court noted that “[f]ew actions could be farther outside the ordinary course of business for a single asset entity than selling its sole asset, and yet that is expressly authorized by majority vote.”
The only actions requiring unanimous consent are dissolution of the LLC, acquisition of additional property and modification of the agreement itself. That these corporate actions (and no others) were specifically carved out of the majority rule norm was of significance to the court. Invoking the maxim expressio unius est exclusio alterius (“the express mention of one thing implies the exclusion of the other”), the court found that the enumeration of these corporate actions as requiring greater than a majority vote implied the exclusion of other corporate actions at the heightened voting standard. In sum, the court concluded that “the operating agreement  sets forth a reasonable and sound governance agreement that dictates majority rule on all matters other than one which changes the nature of the Debtor, leads to its termination or changes the original agreement among the members as to how they would conduct the affairs of the Debtor.”
The dissenting members also argued that the Maryland Limited Liability Company Act requires unanimous consent of the members to file a bankruptcy petition. This argument was quickly dismissed because “[a]lthough the Act requires unanimous consent of the members to authorize a bankruptcy filing, that provision is expressly qualified by ‘unless otherwise agreed.’” The Maryland Act, like its counterpart in many other states, provides a default set of rules for the management, control and operation of LLCs. And as is the case in many other states, most of these rules can be modified by the parties as they may “otherwise agree.” The court acknowledged that “[t]he Act provides great flexibility to members of LLCs in the creation of their governance documents.” It is only when the members choose not to agree on certain governance principles that the Act controls. Because the court was able to infer a majority vote requirement from the operating agreement itself, “maximum effect” was given to that agreement.
The holding of Solomons One follows a trend of remaining within the bounds of the operating agreement to determine governance matters. The court’s interpretation of the operating agreement parallels another decision we recently covered, In re East End Development, LLC, where the United States Bankruptcy Court for the Eastern District of New York denied a motion to dismiss under similar circumstances. In East End, the court found that although the operating agreement did not grant “explicit authority” to the managing member to file for bankruptcy, it provided that member with “broad powers to manage the Debtor’s operations,” subject only to “narrow and specific” circumstances requiring consent of the non-managing members.
The takeaway is rather simple. Although it’s difficult for those forming an LLC to envision a bankruptcy filing, those party to an LLC agreement should consider the unfortunate reality that businesses can (and do) sometimes take a turn for the worse. Any dispute as the circumstances under which that business can be placed into bankruptcy can be avoided (or at least ameliorated) by inserting clear language setting forth the parties’ understanding in the operating agreement.