How Remote is Bankruptcy Remote? Is an Operating Agreement Restriction Against a Bankruptcy Filing Without the Unanimous Consent of All Members Enforceable?

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Nonrecourse financing is common in today's commercial real estate lending market. So too are the use of special purpose entities ("SPEs") and limited guaranties from SPE members of all or a portion of the debt, the latter of which may be triggered by the voluntary bankruptcy case of, or the consent to the entry of an order for relief in an involuntary bankruptcy case filed against, the SPE borrower.

To minimize the risk of a bankruptcy filing by the SPE, the SPE operating agreement typically restricts or limits the manager, managing member, or entity from taking certain material actions without the unanimous consent of all members. So what happens if all of the SPE members do not consent to a bankruptcy filing and the manager of the SPE files a voluntary bankruptcy petition anyway? The answer has varied. In a recent decision, In re Bay Club Partners – 472, LLC, 2014 Bankr. LEXIS 2051 (Bankr. D. Or. 2014), however, the court allowed the bankruptcy case to proceed despite operating agreement restrictions to the contrary and without the unanimous consent of the SPE members. Bay Club Partners highlights the potential problems with trying to enforce operating agreement restrictions against the filing of bankruptcy and the need to consult with legal counsel to reduce the risk that the intention of the parties will be ignored.

Bay Club Court Allows Bankruptcy to Proceed Despite Operating Agreement Restrictions

Bay Club was an Oregon limited liability company formed to acquire, renovate and operate a large apartment complex in Mesa, Arizona. Bay Club obtained a $23.6 million loan to acquire the complex, secured by a deed of trust against the property. Bay Club was a manager-managed limited liability company, in which the manager was authorized to enter into certain transactions and make certain decisions concerning the business affairs of the entity. Notwithstanding the delegation of authority to the manager, Bay Club's operating agreement – in a section entitled "Special Purpose Entity Restrictions" - expressly prohibited the filing of a bankruptcy petition on behalf of Bay Club or consent to the filing of an involuntary bankruptcy petition against Bay Club while the secured loan remained outstanding.

Despite multiple modifications, which extended the loan maturity to March 1, 2014, Bay Club defaulted on the loan and restructuring negotiations broke down. With the impasse, a Written Consent and Resolutions of Bay Club Members was prepared seeking authorization for Bay Club's chapter 11 bankruptcy filing. Three of Bay Club's four members, representing 80% of the ownership interests, consented to Bay Club's bankruptcy filing, but one member refused to consent despite repeated requests. Bay Club's manager nevertheless filed a voluntary chapter 11 petition on behalf of Bay Club.

The secured lender, joined by the dissenting member, then filed a motion to dismiss Bay Club's bankruptcy case, arguing that Bay Club's operating agreement prohibited the filing and Bay Club's manager was not authorized to file for bankruptcy. The bankruptcy court denied the motion to dismiss.

The court first held that the outright restriction against filing for bankruptcy in the operating agreement, which the court characterized as a bankruptcy waiver provision, violated public policy and was unenforceable. The court rejected the argument that Bay Club's members agreed among themselves not to file for bankruptcy, finding that the restriction was included in the operating agreement at the lender's behest and was nothing more than a maneuver by an "astute creditor" to deprive Bay Club of the benefits of bankruptcy. The court then held that Bay Club's operating agreement conferred broad authority on its manager to take actions both inside and outside the ordinary course of business. Thus, the court held that Bay Club's manager was authorized to commence a bankruptcy on Bay Club's behalf despite the operating agreement restrictions against such action and the lack of unanimous consent of the members.

Other Courts Have Dismissed Bankruptcy Cases that Were Commenced Without the Requisite Authority

The decision in Bay Club Partners contrasts with other recent decisions from courts in Colorado and Delaware, which found that authority to commence a bankruptcy case on behalf of an entity is determined under state law. In DB Capital Holdings, LLC, 2010 Bankr. LEXIS 4176 (10th Cir. B.A.P. 2010), the Bankruptcy Appellate Panel for the Tenth Circuit upheld the dismissal of a bankruptcy case on facts nearly identical to Bay Club Partners. The Bankruptcy Appellate Panel held that a "bankruptcy case filed on behalf of an entity without authority under state law to act for that entity is improper and must be dismissed. Bankruptcy courts must look to state law to determine who has authority to commence a bankruptcy case on behalf of a limited liability company ("LLC") organized pursuant to state law." The Panel found the operating agreement in DB Capital Holdings expressly barred the filing of a bankruptcy petition altogether, rejecting the argument that the restriction should be invalidated "because it was executed at the demand, and for the sole benefit of Debtor's main secured creditor." Distinguishing instances in which a debtor waived the protections of bankruptcy with a third party, the Panel found that an agreement among members of a limited liability company was not void as against public policy. The Panel further observed that Colorado courts construe operating agreements under general contract law principles.

Finding that the operating agreements required the unanimous written consent of the members to commence a bankruptcy case, the bankruptcy court in Green Bridge Capital S.A., et. al. v. Ira Shapiro (In re FKF Madison Park Group Owner, LLC), 2011 Bankr. LEXIS 344 (Bankr. D. Del. 2011), reached the same conclusion as the court in DB Capital Holdings. There, the court ruled that "[t]he controlling legal principles are not complex and command the result. A party cannot subject an entity to bankruptcy without authority. Determining authority is a question of state law, and in the case of a limited liability company is governed by the operating agreement, which defines the rights of members."

The decisions in Bay Club Partners, DB Capital Holdings, and FKF Madison Park highlight the uncertainty whether a restriction in an operating agreement against the filing of bankruptcy will be respected. The cases further highlight the importance of consulting with legal counsel to carefully review and advise regarding the authority delegated under and the restrictions in operating agreements and related documents.

Topics:  Commercial Bankruptcy, Nonrecourse Loans, SPEs

Published In: Bankruptcy Updates, Business Organization Updates, General Business Updates, Finance & Banking Updates, Commercial Real Estate Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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