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Court Invalidates Prohibition on Bankruptcy Filing in LLC Operating Agreement as Unenforceable Lender Ploy

PSZJ Bulletin No. 16
May 2014

Bankruptcy court refuses to enforce lender-inspired provision of LLC operating agreement that LLC “shall not institute” bankruptcy or insolvency proceedings until lender’s indebtedness is paid in full.

In a decision that may have significance for any troubled company (and thus for its investors and lenders), an Oregon bankruptcy court has refused to enforce a provision in the formation document of a limited liability company that purported to deprive it of the authority to file a bankruptcy case.

BACKGROUND

In In re Bay Club Partners – 472, LLC, Case No. 14-30394 (Bankr. D. Ore. May 06, 2014), Bay Club, an Oregon LLC, borrowed approximately $24M from Legg Mason’s predecessor in interest to acquire, renovate, and operate an apartment complex in Arizona. The loan was secured by a deed of trust on the property.  After several loan modifications and an unsuccessful negotiation for a further forbearance and modifications, Bay Club filed a chapter 11 petition.

Legg Mason filed a motion to dismiss the bankruptcy petition on the grounds that the bankruptcy filing was not authorized by the LLC’s operating agreement, relying on a provision in the LLC operating agreement that provided that:

(Emphasis added.)

THE DECISION

In addressing Legg Mason’s motion to dismiss, the court first considered the debtor’s argument that as a creditor, Legg Mason had no standing to challenge the bankruptcy filing on the ground that it was not properly authorized. Noting that “[c]ourts around the country are split on the question of whether creditors have standing to challenge a business entity bankruptcy filing on the ground that it was not properly authorized,” the bankruptcy court concluded that Legg Mason did have such standing.

Turning to the merits, the court noted that much of the parties’ argument focused on whether the operating agreement’s restriction on bankruptcy filing was consistent with Oregon LLC law. The bankruptcy court concluded, however, that the matter was governed by federal law, and that the provision in question constituted a waiver of the company’s right to avail itself of the protections of the Bankruptcy Code, “and it is unenforceable as such, as a matter of public policy.”

In reaching this conclusion, the court noted that there was no evidence that Legg Mason insisted on a bankruptcy waiver in its loan agreements, and instead adopted a “more cleverly insidious approach.” Specifically, Legg Mason requested the inclusion of the relevant provision in the operating agreement with its requests for other restrictive covenants. The “no bankruptcy” provision apparently was included in the agreement without discussion among the members. The court concluded as follows: “That the members of Bay Club signed the Operating Agreement among themselves rather than acquiescing in the bankruptcy waiver provision in a loan agreement with Legg Mason is a distinction without a meaningful difference.” After reaching this conclusion, the court found that the chapter 11 filing was properly authorized.

BROADER IMPLICATIONS

The court’s reasoning in ruling that a prohibition on filing bankruptcy in a company’s formation document was ineffective has broader implications that may be of interest, not only to a creditor or lender of a company, but also to parties hoping to purchase a “loan to own” and hoping to rely upon such bankruptcy-unfriendly provisions for comfort. The court’s rejection of the bankruptcy-filing prohibition inserted in a document to which the lender was not a party based on the court’s view of the lender’s requirement for this prohibition as being a “cleverly insidious approach” and a “distinction without a meaningful difference,” if applied in other contexts, might result in other bankruptcy filing limitations being rejected. By example, a court may refuse to give effect to a provision in a corporation’s articles that requires the consent of the preferred shareholder to file a bankruptcy case where the preferred interests are held wholly by a lender (or even by a single purchaser of newly-issued preferred shares) or a court may refuse to give effect to a provision in a corporation’s articles that requires the unanimous consent of directors to authorize a corporate bankruptcy filing where there also is a contractual provision entitling the lender to control the selection of one director (who could veto a bankruptcy filing).

Please contact Isaac Pachulski for more information on Bay Club Partners