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Can I Really Prevent an LLC from Filing for Bankruptcy? Maybe...

We are continually asked if there is anything a creditor can do to prevent an entity from filing for bankruptcy. A unpublished decision from the U.S. Bankruptcy Appellate Panel (BAP) of the Tenth Circuit may provide one solution involving limited liability companies (LLCs): a contractual provision prohibiting the filing of a bankruptcy petition. Although this type of provision is generally considered unenforceable as against public policy, the Tenth Circuit decision found that provisions in an LLC's operating agreement can prevent the filing of a bankruptcy case.

The facts of the case, DB Capital Holdings, LLC v. Aspen HH Ventures, LLC (In re DB Capital Holdings, LLC), are relatively straightforward. DB Capital (the debtor), a manager-operated Colorado LLC, was formed to develop and sell a luxury condominium project in Aspen. The two members of the LLC, Aspen HH Ventures and Dancing Bear Development, agreed to grant management authority to an entity related to Dancing Bear. An operating agreement was the principal document that governed the debtor's operation. About four years prior to the bankruptcy filing, the operating agreement was amended to add a provision expressly barring the LLC from filing for bankruptcy.

When the debtor defaulted on its loans with its lender, a dispute broke out between the two members of the LLC. Aspen HH sought to dissolve the debtor and appoint a receiver in state court. Shortly thereafter, the debtor's manager filed a Chapter 11 bankruptcy petition. In response, Aspen HH filed a motion to dismiss the Chapter 11 case alleging that the manager had filed the petition without authorization. The bankruptcy court granted Aspen HH's motion and dismissed the case. The debtor subsequently appealed to the BAP of the Tenth Circuit.

On appeal, the BAP began its analysis with the premise that a bankruptcy case can only be filed by someone with authority to do so. Otherwise, the bankruptcy case is improper and must be dismissed. The BAP's first step was to look at applicable state law to determine if the manager had authority to file the bankruptcy. Under the Colorado LLC Act, an operating agreement governs the rights and duties of an LLC's members and managers. Here, the operating agreement was clear; it expressly barred the LLC from filing a bankruptcy petition.

The manager argued that the provisions in the debtor's operating agreement preventing a bankruptcy filing should be deemed unenforceable as against public policy. The BAP, distinguishing this case from those where a secured lender sought to prohibit a debtor from filing for bankruptcy, stated that the debtor "has not cited any cases 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 to public policy." The BAP also found that even if the amendment to the debtor's operating agreement was deemed unenforceable, the manager still would have lacked authority to file a bankruptcy case because (1) the operating agreement's general grant of authority to the manager to conduct the affairs of the LLC did not constitute specific authority to file a bankruptcy, and (2) the operating agreement precluded the manager from taking any action that would make it impossible to carry on the ordinary business of the debtor. The BAP found that the filing of a bankruptcy case would constitute an act that would prevent the ordinary business of the debtor and, accordingly, upheld the bankruptcy court's dismissal of the case.

Although this decision upheld the operating agreement's express bar on any bankruptcy filing, the BAP qualified its opinion by declining "to opine whether, under the right set of facts, an LLC's operating agreement containing terms coerced by a creditor would be unenforceable."

It is important to recognize that this dispute was between members of the LLC, as opposed to a lender seeking to preclude a borrower from filing for bankruptcy. However, given the freedom members have in drafting the governing LLC documents, there is an open issue as to whether lenders can require language (either in the original operating agreement or added at a later date through an amendment) that prohibits a bankruptcy filing and whether such a requirement would be "coercive." Even if a lender can require such a provision, it would need a way to limit the members' ability to amend the agreement to remove the prohibition. If the lender could not prohibit the removal of the provision, members of the LLC could ultimately vote to amend the operating documents without the lender's consent. Accordingly, a lender would have to be a member of the LLC or have a representative act as a member and vote against the removal of any such provision.

If the entity is a Delaware LLC, another alternative may be to rely upon section 18-101(7) of the Delaware LLC Act. This provision states that an LLC agreement may provide rights to a third party that is not a party to the LLC agreement. Thus, the LLC agreement could prevent such a provision from being amended without the consent of a third party, such as a lender.

As a side note, even though Aspen HH was able to dismiss the bankruptcy case, it was not successful in its attempt to dismiss an involuntary bankruptcy case brought by other creditors of the debtor. Which just goes to show you, while you can control some things, you can't control everything.

© 2022 Much Shelist, P.C.National Law Review, Volume II, Number 79
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About this Author

Jeff Schwartz, bankruptcy attorney, Much Shelist law firm
Principal

Jeffrey M. Schwartz, a Principal in the firm's Creditors' Rights, Insolvency & Bankruptcy group, focuses his practice on the representation of secured and unsecured creditors in business reorganizations under Chapter 11 of the Bankruptcy Code and in out-of-court restructurings. He also represents buyers and sellers of financially distressed companies and distressed debt, and regularly advises lenders, creditors' committees, indenture trustees, debtors and other parties involved in bankruptcy-related matters. 

312-521-2626
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