Wave Goodbye to Bankruptcy Waivers? (Court Rules LLC’s Prepetition Waiver of Bankruptcy Protection Contrary to Public Policy)

Contributed by Erika del Nido
Secured creditors naturally want to be repaid. Sometimes secured creditors go as far as asking a debtor to waive its right to seek bankruptcy protection. Although such clauses are frequently held to be unenforceable, we previously have discussed exceptions for LLCs. A recent case from the United States Bankruptcy Court for the District of Oregon, In re Bay Club Partners-472, LLC, joins the debate, albeit holding just the opposite — an “astute creditor’s” “cleverly insidious” bankruptcy waiver in an LLC operating agreement is not enforceable.
Bay Club Partners-472, LLC is a limited liability company that was formed to renovate and operate an apartment complex in Arizona. Prepetition, Legg Mason Real Estate CDO I, Ltd.’s predecessor loaned $23.6 million to Bay Club for the purchase of the apartment complex, and several years later, Bay Club defaulted.
Bay Club is a “member-managed” LLC organized under the laws of Oregon, which means that any matter relating to the LLC’s business may be exclusively decided by the manager. Although Bay Club’s LLC operating agreement grants broad authority to the manager, it contains a “Special Purpose Entity Restriction,” which provides that Bay Club “shall not institute proceedings to be adjudicated bankrupt or insolvent . . . or file a petition seeking . . . relief under any applicable federal or state law relating to bankruptcy” until such time as the Legg Mason loan has been repaid in full. Prepetition, Legg Mason requested the inclusion of this provision in Bay Club’s operating agreement.
In January 2014, Bay Club sought chapter 11 protection in the United States Bankruptcy Court for the District of Oregon. Bay Club’s chapter 11 petition was signed by its manager, and a consent resolution was prepared that reflected the support of three of four of Bay Club’s members, constituting 80% of the membership interests. Trail Ranch Partners, LLC, a 20% member owner of Bay Club, opposed the bankruptcy filing.
Legg Mason filed a motion to dismiss Bay Club’s chapter 11 case for cause pursuant to section 1112(b) of the Bankruptcy Code, arguing that Bay Club’s LLC operating agreement prohibited the bankruptcy filing and that Bay Club’s manager was not authorized to file for bankruptcy absent approval of 100% of the LLC members. Trail Ranch joined Legg Mason’s motion to dismiss.
Bay Club argued that Legg Mason, as a creditor, lacked standing under section 1109(b) of the Bankruptcy Code to prosecute its motion to dismiss the case. The bankruptcy court acknowledged that courts are split on whether creditors have standing to challenge corporate bankruptcy filings as unauthorized. Some courts have held that section 1109(b)’s “expansive” language provides for standing (“[a] party in interest, including . . . a creditor . . . may raise and may appear and be heard on any issue in a case under this chapter”). In contrast, other courts have held that creditors lack standing, based on a pre-Bankruptcy Code Supreme Court decision in Royal Indem. Co. v. Am. Bond & Mortg. Co., and based on such courts’ concern that creditors are seeking dismissal out of self-interest and not the best interests of all creditors. The Bay Club court observed that, in the Ninth Circuit, only those “who are directly and adversely affected pecuniarily” by an issue before the bankruptcy court have standing to challenge requested relief, citing the Ninth Circuit’s decision in Fondiller v. Robertson (In re Fondiller), which held that an insolvent debtor does not have standing to appeal order affecting the size of his estate because such order would not diminish debtor’s property or affect his rights.
Applying the plain language of section 1109(b) and the Fondiller standard, the court found that Legg Mason, as the primary (and possibly only) secured creditor, had “a direct pecuniary interest” in whether Bay Club can proceed in chapter 11 and concluded that it had standing to prosecute the motion to dismiss.
Turning to the prepetition waiver of the right to file a bankruptcy case, the court commented that the Ninth Circuit “has been very clear” that such waivers are unenforceable as a violation of public policy. Without such a rule, creditors likely would always require debtors to waive their bankruptcy rights. According to the court, the fact that the bankruptcy waiver was contained in the operating agreement, as opposed to the loan agreement, was a “cleverly insidious” “maneuver of an ‘astute creditor.’” The court held that the provision is unenforceable as a matter of public policy.
Next, after holding the bankruptcy waiver unenforceable, the court turned to the question of whether Bay Club’s chapter 11 filing was authorized. Referring to the manager’s broad authorities in the operating agreement, the court concluded that the manager’s attempts to seek approval from all members was merely an effort to avoid disputes such as the motion to dismiss, but it did not detract from the manager’s powers to “take all actions necessary to further the business interests of Bay Club.” In denying the motion to dismiss, the court held that the manager had the authority to commence Bay Club’s chapter 11 case and that the case was properly authorized.
Courts are wavering on bankruptcy waivers! Bay Club Partners reminds us that some “bankruptcy remote” provisions carry a not-so-remote risk that the court will find the provision unenforceable and contrary to public policy. Although the case contributes to the dialogue on bankruptcy waivers, it likely is not the last word. What bankruptcy waiver provisions are reasonable? Where is the line between legitimate creditor protection and a violation of public policy? Do small LLC’s and large companies face different rules? Who has standing to enforce such provisions? We will keep you informed of the latest developments.