Public Policy Prohibits Contractual Restrictions on an LLC’s Right to File Bankruptcy
The Business Advisor
Generally, public policy prohibits attempts to contract away the right to file bankruptcy, and a string of recent decisions confirms this principle in the context of limited liability company (“LLC”) operating agreements. In September, the United States Bankruptcy Court for the Eastern District of Kentucky held that provisions of an LLC operating agreement, added incidental to the closing of a commercial loan, served no purpose other than to frustrate the LLC’s ability to commence a bankruptcy case, and were thus unenforceable. In re Lexington Hosp. Grp., LLC, 2017 WL 4118117 (Bankr. E.D. KY, Sept. 15, 2017). In short, the applicable provisions gave the lender the ability to block a filing. Notwithstanding state law policy of freedom of contract in LLC agreements, the bankruptcy court observed that enforceability of bankruptcy restrictions is a matter of federal law. The Court’s holding follows two other recent decisions similarly voiding restrictions on bankruptcy rights. See In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016); In re Lake Michigan Beach Pottawattamie Resort, LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016).
In Lexington Hospitality, the LLC’s original operating agreement contained no limitations on its manager’s and/or members’ ability to file bankruptcy on the LLC’s behalf. 2017 WL 4118117 at *2. The LLC later executed an amended operating agreement in connection with its acquisition of a hotel; the amended agreement (the “Agreement”) granted the lender a 30% equity stake until the loan was fully repaid. Id. at *2-3. The Agreement also provided for the appointment of an “Independent Manager” and vested the sole discretion to file bankruptcy on behalf of the LLC in that person: (i) “The Company may declare bankruptcy only so long as the Independent Manager authorizes such action” and (ii) “In order for the Company to declare Bankruptcy or dissolve and liquidate its assets, the Independent Manager must provide authorization, and then only upon a 75% vote of the Members.” Id. at *3. The Agreement set forth a list of nine requirements that attempted to preserve the Independent Manager’s independence. Id. It then limited the Independent Manager’s ability to act, vote, or otherwise participate in any LLC matters other than to consent to file bankruptcy. Id. The Independent Manager was instructed to consider the interests of the LLC in acting or otherwise voting, as well as the interests of creditors and the economic interests of a minority member that was controlled by the lender. Id. The Agreement also eliminated any fiduciary duty or liability that the Independent Manager might have to other members or managers. Id. And, the Independent Manager’s role terminated upon repayment of the Loan. Id.
An addendum to the Agreement contained a further restriction on the LLC’s right to file a bankruptcy petition: “[The LLC shall not file bankruptcy] without the advance, written affirmative vote of the Lender and all members of the Company.” Id. That provision directly conflicted with the Independent Manager provisions, which only required a 75% vote of the Members.
The LLC filed a petition for chapter 11 relief signed by its manager pursuant to a corporate resolution authorizing such action. Id. at *4. The resolution disclaimed any knowledge as to the contact information or whereabouts of the Independent Manager and did not indicate a member vote was taken. Id. Three days later, the lender filed a motion to dismiss the bankruptcy case, arguing that the Agreement’s bankruptcy restrictions were not followed. Id.
In analyzing the Agreement’s enforceability, the bankruptcy court first noted that “state law governs whether a business entity is authorized to file a bankruptcy petition.” Id. at *5. Kentucky law permitted the LLC’s member to do so, absent the Agreement’s restrictions in favor of the lender. Id. The court then turned to federal law and public policy to determine whether the restrictions were enforceable.
Federal Public Policy Against Bankruptcy Restrictions
Parties to an operating agreement generally have the freedom to contract limited only by the parameters in the relevant articles of organization and statutory law. Id. But, there is a strong federal public policy in favor of allowing individuals and entities their right to a fresh start in bankruptcy. Thus, cases discussing bankruptcy restrictions in LLC operating agreements usually begin with the uncontested premise that entities, like individuals, cannot contract away access to bankruptcy relief. See, e.g. In re Squire Court Partners Ltd. P’ship, 2017 U.S. Dist. LEXIS 105032, at *9 (E.D. Ark. July 7, 2017); Lake Michigan Beach, 547 B.R. 899; Intervention Energy, 553 B.R. 258; In re Bay Club Partners 472, LLC, 2014 WL 1796688, at *1 (Bankr. D. Or. May 6, 2014); Continental Ins. Co. v. Thorpe Insulation Co., 671 F.3d 1011, 1026 (9th Cir. 2012) (“This prohibition of prepetition waiver has to be the law; otherwise, astute creditors would routinely require their debtors to waive.” (quotation and citation omitted)). As the Lexington Hosp. court noted, “[i]ndeed, since bankruptcy is designed to produce a system of reorganization and distribution different from what [sic] would obtain under nonbankruptcy law, it would defeat the purpose of the Code to allow parties to provide by contract that the provisions of the Code should not apply.” Lexington Hosp., 2017 WL 4118117 at *5 (citing In re 203 N. LaSalle St. P’ship, 246 B.R.325, 331 (Bankr. N.D. Ill. 2000)). Based on those policy considerations, contractual provisions in operating agreements that effectively block the entity’s ability to file bankruptcy without a creditor’s consent have been held void. Id. (citing Intervention Energy Holdings, 553 B.R. at 263-264; Lake Michigan Beach, 547 B.R. at 913).
In Lake Michigan Beach, the LLC debtor defaulted on a debt and agreed to give the creditor “special member” status in exchange for a promise not to pursue the default. 547 B.R. at 903-04. The amended operating agreement made the creditor a member with the right to approve or disapprove a bankruptcy filing by the debtor. Id. The creditor had no interest in the LLC’s profits or losses, no right to distributions, no tax consequences, and no obligation to make capital contributions to the LLC. Id. The creditor “was kept separate and apart from the Debtor in all ways but for its authority to block the Debtor from petitioning for bankruptcy relief.” Id.
In Intervention Energy, the LLC debtor defaulted on its debt and agreed to make the creditor a common member in exchange for waiver of all defaults. 553 B.R. at 261. The amended operating agreement required unanimous consent from members to file for bankruptcy. Id. The effect of the amendment was to grant the creditor, holder of 1 membership unit out of 22 million, full veto power over a bankruptcy filing. Id. at 260-261.
In Bay Club, the LLC debtor received a real estate purchase money loan secured by the property and the LLC’s related assets. 2014 Bankr. LEXIS 2051 at *1-3. The lender asked the debtor to add a bankruptcy waiver provision and other restrictive covenants to its operating agreement. Id. at *3. The amended agreement provided that the debtor “shall not institute proceedings to be adjudicated bankrupt or insolvent” until “the indebtedness secured by that pledge is paid in full.” Id.
The form that a contractual bankruptcy waiver may take is limited only by the resourcefulness of attorneys. Squire Court Partners, 2017 U.S. Dist. LEXIS 105032 at *11 (citing Intervention Energy 553 B.R. at 264). The bottom line, however, is that in all of the recent decisions, the provision amounted to a debtor agreeing to a prepetition waiver. See id. Moreover, each case involved a creditor limiting a debtor’s right to seek bankruptcy relief as a condition of supplying credit. Id. Each of these “blocking provisions” violated federal public policy. Id.
Lexington Hospitality Group’s Amended LLC Agreement
In Lexington Hosp., the court invalidated the bankruptcy restrictions in the amended LLC Agreement. First, the court found that the Independent Manager was “not a truly independent decision maker,” despite the existence of provisions that appeared to require independence. Lexington Hosp., 2017 WL 4118117 at *6. The Independent Manager’s fiduciary duties to the company were abrogated by her contractual duties to creditors and the minority member controlled by the lender. Id. at *7. The Independent Manager’s existence was also terminated upon payment of the debt; “this connection with the financing highlights the concern that the Independent Manager is not actually independent from the creditor who negotiated for her participation in a bankruptcy decision.” Id.
In any event, even if those provisions were not enough to invalidate the restrictions, the court determined that following provision “confirms that the Independent Manager is merely a pretense to suggest that the right to file bankruptcy is not unfairly restricted”—“In order for the Company to declare Bankruptcy or dissolve and liquidate its assets, the Independent Manager must provide authorization, and then only upon a 75% vote of the Members.” Id. The 75% requirement, while purporting to reserve the LLC members’ bankruptcy rights, actually disguised the true impact of the restriction because as part of the loan transaction, the LLC’s majority owner diluted its 100% ownership interest to give a 30% interest to an entity controlled by the lender. Thus, it was impossible for the LLC to achieve 75% without the lender’s consent. Id.
Finally, the lender’s power to prohibit a bankruptcy filing was even more direct in the addendum to the Agreement, which gave the lender express veto power regardless of the members’ consent to a bankruptcy filing. For all of those reasons, the bankruptcy restrictions were deemed unenforceable. Id. at *8.
“Acceptable” Bankruptcy Restrictions
Not all bankruptcy restrictions are unenforceable, however. Members of a business entity, even a non-fiduciary member or manager, may freely agree among themselves not to file bankruptcy. See, e.g., Lexington Hosp., 2017 WL 4118117 at *6. Thus, the issue is whether bankruptcy restrictions are imposed by a creditor to create an absolute waiver of the LLC debtor’s right to file bankruptcy. 2017 WL 4118117 at *6. With respect to such restrictions in favor of outside parties to an LLC—such as the appointment of an “independent director” with veto power over a bankruptcy filing—the rule is that “the director must be subject to normal director fiduciary duties and therefore in some circumstances vote in favor of a bankruptcy filing, even if it is not in the best interests of the creditor that they were chosen by.” Lake Michigan Beach, 547 B.R. at 913. Absent normal fiduciary duties, “allowing a creditor to contract for control of a debtor’s decision whether to file a bankruptcy petition would undermine the most fundamental purposes of the bankruptcy laws.” Squire Court Partners, 2017 U.S. Dist. LEXIS 105032 at *12 (citing Lake Michigan Beach, 547 B.R. at 914).
The key takeaway for parties considering restrictions on an LLC’s bankruptcy rights is that an independent decision maker installed by an outside creditor cannot exist simply to vote “no” to a bankruptcy filing, but must also have normal fiduciary duties. See Lexington Hosp., 2017 Bankr. LEXIS 3129, at *16 (citing Lake Michigan Beach, 547 B.R. at 911-913). This is consistent with the rule that upon insolvency (and in some states in the so-called “zone of insolvency”), fiduciary duties shift from equity holders to all creditors. Contractual provisions cannot alter existing common law and/or statutory fiduciary duties for the sole benefit of one creditor. Further, as the discussion in Lexington Hosp. makes clear, the purpose of a contractual restriction on bankruptcy, and the factual circumstances surrounding its adoption, may affect enforceability as much as the contract language itself.