Let’s Call the Whole Thing Off: What Happens if the Bankruptcy Code Says Yes, But the Debtor’s Governance Documents Say No?

Contributed by Christopher Hopkins
As a general matter, governance provisions in a chapter 11 debtor’s organizational documents continue to apply postpetition.  But what if those governance provisions prevent the debtor from engaging in an act expressly authorized by the Bankruptcy Code?  This issue was recently addressed by the United States Bankruptcy Court for the Southern District of Florida in In re DocAssist, LLC, where the court held that a debtor-LLC could not obtain postpetition financing pursuant to section 364 of the Bankruptcy Code without first obtaining the approval of a supermajority of its members as required by its operating agreement.
In re DocAssist, LLC
The dispute in DocAssist, though addressed in the bankruptcy context, was essentially a two-party governance dispute.  Formed as a Florida LLC, the debtor’s members consisted of two factions: the majority members, which owned a 64.16% equity interest in DocAssist, and the minority members, which owned the remaining 33.84%.  The majority members were also the debtor’s primary prepetition lenders, providing nearly $3.8 million in capital through a number of unsecured loans.  Prepetition, the majority had tried to effect certain amendments to the debtor’s operating agreement in an effort to extinguish the minority members’ interest in the LLC, which were subsequently invalidated in state court.  Unwilling to concede defeat, however, the majority members caused the debtor to file a prepackaged chapter 11 plan in the United States Bankruptcy Court for the Southern District of Florida in an attempt to wipe out the minority members’ interest through a plan of reorganization.
The majority members’ proposed plan would extinguish all existing equity interests in the debtor and convert all prepetition loans into all of the equity of the reorganized LLC.  Because the majority members were the debtor’s primary prepetition lenders, the restructuring would leave the majority members with the overwhelming majority of the reorganized LLC’s equity, effectively wiping out the minority members’ interest.  In addition, the plan provided that one of the majority members would provide $100,000 in postpetition financing pursuant to section 364 of the Bankruptcy Code.  Shortly after the petition date, the minority members objected to the entirety of the debtor’s plan, including the postpetition financing, and asked the court to dismiss the debtor’s chapter 11 case.
Although the court ultimately abstained from the case on the ground that the debtor’s chapter 11 case amounted to a “naked attempt to avoid the governance determinations by the State Court,” and, therefore, there was “no economic need or purpose for [the debtor] to be in [c]hapter 11,” the court took particular issue with the debtor’s proposed postpetition financing.  Pursuant to the debtor’s operating agreement, certain “Major Decisions” required the supermajority approval of 66.67% of the members’ equity interests, and the incurrence of any debt over $25,000 constituted a “Major Decision.”  Absent the consent of the minority members, therefore, the majority members could not cause the debtor to incur more than $25,000 in postpetition financing if the operating agreement remained in effect postpetition.
The majority members argued that the governance provisions of DocAssist’s operating agreement ceased to apply upon the commencement of its chapter 11 case and that it was free to incur postpetition financing in any amount subject only to its own business judgment and the review and approval of the bankruptcy court.  The court gave this argument short shrift, however, concluding that it was “nonsense” to suggest that a chapter 11 debtor was free to act in a manner inconsistent with its governing documents.  Although the court’s decision was likely influenced in view of the majority members’ intentions in commencing the debtor’s bankruptcy case, the court did not limit its holding to cases where the controlling shareholder or majority member engages in misconduct.  Rather, the court reasoned that because the supermajority requirement was enforceable under Florida law, and no provision of the Bankruptcy Code provides a different result, the debtor remained bound by the governance provisions of its operating agreement postpetition.
Given the unique circumstances surrounding the dispute in DocAssist, it remains to be seen whether the court would reach a similar conclusion in a legitimate chapter 11 case.  Although the court’s reasoning in DocAssist did not depend on a finding of misconduct by the controlling party, the court was clearly agitated by the majority members’ thinly veiled attempt to exploit the chapter 11 process to circumvent the state court proceedings that frustrated their previous attempt to extinguish the minority members’ interest.  Nonetheless, the court’s holding may have troubling implications for debtors whose organizational documents contain similar restrictions to those at issue in DocAssist.  For example, could the minority members have used their effective blocking position to prevent the debtor from obtaining any postpetition financing in excess of $25,000 in order to force a liquidation of the LLC?  The opinion in DocAssist seems to say “yes,” suggesting that holders of a minority interest in a debtor could use governance provisions in a debtor’s operating agreement to effectively hijack the chapter 11 process by simply withholding their consent, even where the debtor’s proposed action (such as obtaining postpetition financing pursuant to section 364) is expressly authorized by the Bankruptcy Code.