Chapter 11? No Thank You! Courts Find Restrictions on Bankruptcy Filings in LLC Agreements Enforceable

Article Contributed by Christopher Linden and Kyle J. Ortiz
Courts have ample experience with bankruptcy remote entities and have long held that provisions in organizational documents or loan agreements purporting to waive the protections of the Bankruptcy Code, or the right to file a petition entirely, are unenforceable.  In contrast, parties routinely respect and follow provisions in governance documents that impose procedural hurdles on a bankruptcy filing, such as unanimous consent by directors (of a corporation) or managers (of an LLC).  Two recent decisions, however, call this well-established distinction into question in the context of limited liability company (“LLC”) operating agreements, stating that, absent any evidence of lender coercion, such provisions will be enforced.
In In re DB Capital Holdings, LLC, Nos. CO-10-046, 10-23242, 2010 WL 4925811 (B.A.P. 10th Cir. Dec. 6, 2010), the Tenth Circuit Bankruptcy Appellate Panel held that an LLC’s manager lacked authority to file a chapter 11 petition because the LLC’s operating agreement contained language explicitly prohibiting the manager from taking such action.  The debtor was a manager-operated Colorado LLC that developed and sold luxury condominiums in Aspen, Colorado.  The two members of the LLC (Aspen HH Ventures, LLC (Aspen) and Dancing Bear Development, LC (DB Development)) agreed to hand over management of the LLC to the general partner of DB Development, Dancing Bear Management, LLC (the “Manager”).  The arrangement was governed by a January 2006 Operating Agreement and a formal amendment to the Operating Agreement entered into in May 2006.
The May 2006 amendment added an explicit bar on filing a bankruptcy petition, stating that the company:

to the extent permitted under applicable Law, 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.

The original Operating Agreement did not likewise prohibit the LLC from filing a bankruptcy petition.  This May 2006 amendment to the Operating Agreement was entered into at the behest of the LLC’s primary lender, WestLB, and presumably resulted in the LLC obtaining more favorable loan terms in exchange for the explicit prohibition against commencing a bankruptcy proceeding.
Unfortunately for the debtor, the condominium development was completed 14 months behind schedule and $4 million over budget, which rendered the debtor insolvent and in breach of its loan agreements with WestLB.  Thus, WestLB went to Colorado state court to request the appointment of a receiver.  On May 27, 2010, the state court entered an order scheduling a hearing on the request to appoint a receiver.  In the meantime, the Manager, without consent from the two members of the LLC, caused the debtor to file a chapter 11 bankruptcy petition.  Aspen filed a motion to dismiss the case alleging that the Manager filed the petition both without authorization and in bad faith.  The court did not address the bad faith allegation, but granted the motion, finding that the May 2006 amendment to the Operating Agreement barred the LLC from filing.
The court turned to Colorado’s LLC law and, relying on the general proposition that an act done without requisite corporate authority is invalid, concluded that the bankruptcy case should be dismissed because it was filed in violation of the prohibition in the LLC agreement.  The Manager argued that the provision was put in the amendment at the behest of WestLB, and thus was unenforceable as a matter of public policy, but the court found no evidence of lender coercion and declined to find the provision unenforceable.  The court distinguished the cases presented by the Manager barring prospective prohibitions on filing a chapter 11, reasoning that those cases involved agreements between debtors and third-party creditors not to file, whereas in the current dispute, the agreement was between members of an LLC.  The court even stated that it knew of no case law “standing for the proposition that members of an LLC cannot agree among themselves not to file bankruptcy, and that if they do, such agreement is void as against public policy.”
The DB Capital decision appears to be a dramatic departure from longstanding precedent and, if followed, would permit parties to voluntarily opt out of the federal bankruptcy process.  While this would not prevent creditors from filing an involuntary petition and therefore would not truly make the entity “bankruptcy proof,” it would effectively prevent equity sponsors and management from voluntarily seeking bankruptcy protection.  The court did, however, expressly note that it was not dealing with any allegations of lender coercion, so it remains to be seen if similar restrictions in an LLC agreement survive scrutiny in future cases where lender influence is a factor.
In Green Bridge Capital S.A. v. Ira Shapiro (In re FKF Madison Park Group Owner, LLC), No. 10-56158 (KG), 2011 WL 350306 (Bankr. D. Del. Jan. 31, 2011), Judge Gross considered a provision in the debtor’s LLC operating agreement that placed a secured lender at the helm of the debtor’s bankruptcy case.  The primary debtor entity, a New York LLC, obtained a $238.5 million construction loan from a subsidiary of Credit Suisse.  Needing additional financing, the debtors obtained a $15 million mezzanine loan from another entity.  As part of the mezzanine financing agreement, the mezzanine lender obtained an option — which  it subsequently exercised — to purchase a 35 percent membership interest in the debtor.  Presumably  the lender negotiated this option so that, in the event the LLC became distressed, the borrower would be forced to involve the lender in any restructuring or bankruptcy.  In fact, because the relevant LLC documents required unanimous member consent to authorize material actions (including the filing of a bankruptcy), the option gave the lender a strategically valuable blocking position.
In June of 2010, creditors filed involuntary petitions against the debtors in the Delaware bankruptcy court.  With the consent of the mezzanine lender, the debtor’s president, Shapiro, moved to dismiss the involuntary petitions.  While the mezzanine lender consented to the defense of the involuntary petitions, it made it clear that it was not authorizing any further action.  Nonetheless, Shapiro subsequently withdrew the debtor’s opposition to the involuntary petitions, allowed entry of an order for relief under chapter 7, and agreed to convert the case to chapter 11 without consulting the mezzanine lender.  Shapiro also caused motions to be filed with the bankruptcy court on the debtor’s behalf, requesting appointment of a restructuring officer and approving debtor in possession financing that would prime the first lien lender’s secured interest.  When the mezzanine lender realized that Shapiro was exceeding his authority, and in doing so likely diminishing the value of its claim, it initiated an adversary proceeding and sought to enjoin this conduct.
From the outset, Judge Gross made it clear that the controlling legal principles underlying his decision were “not complex” and “command[ed] the result.”  The court established that the authority to subject an entity to bankruptcy is “a question of state law.”  In the case of a LLC, the relevant provisions of the operating agreement are controlling.  In this case, the debtor’s operating agreement explicitly required the unanimous consent of the LLC members to take material actions.
The court concluded that Shapiro’s acquiescence in the involuntary filing and conversion of the case to chapter 11 were consistent with “defense” of the original involuntary petition, which had been authorized by the mezzanine lender, and therefore found that the cases had been properly commenced with the requisite authority under the LLC operating agreement.  In contrast, the appointment of a restructuring officer and the entry into debtor in possession financing were not authorized and therefore barred.  As a result, Judge Gross granted the requested TRO and threatened to appoint a chapter 11 trustee if the mezzanine lenders and Shapiro could not come to an agreement on how to proceed with the case.
The DB Capital and Green Bridge decisions suggest a willingness among courts to enforce provisions in LLC agreements that limit the debtor’s ability to utilize the fundamental restructuring tools of the Bankruptcy Code, such as the ability to obtain postpetition financing under section 364.  And DB Capital went so far as to conclude that even an outright prohibition on filing for bankruptcy will be enforced where there is no suggestion of lender coercion.  If these decisions are followed, then the holy grail of some lenders — a truly bankruptcy proof entity — may be closer to reality.