Bankruptcy Court Dismisses Company’s Chapter 11 Case, Holding That LLC Agreement that Limited Right to File Bankruptcy Did Not Violate Public Policy

The Bankruptcy Court for the District of New Jersey dismissed a voluntary Chapter 11 petition of a Delaware LLC based on a provision in its LLC agreement that restricted the company’s authority to seek bankruptcy protection. In dismissing the case, Bankruptcy Judge Michael Kaplan rejected the LLC’s arguments that provisions restricting a company’s ability to file a bankruptcy petition violate public policy.

Judge Kaplan Dismisses a Case Filed by an LLC That Failed to Obtain Consent to File from Holders of Ownership Interests as Required by the LLC Agreement

In In re 3P Hightstown, LLC, 2021 WL 3122409 (Bankr. D.N.J. July 22, 2021), the LLC Agreement included a restrictive provision prohibiting the company from filing a voluntary bankruptcy case or consenting to an involuntary case without prior approval of the holders of a majority of the outstanding “Preferred Units” of the LLC.  The Preferred Units had been created and issued to a group of four individuals called the “4J Group” in connection with substantial funding provided by the 4J Group to the LLC.  At the same time, the LLC Agreement was revised to include a restrictive provision that gave the holders of Preferred Units veto power over any effort by the LLC to file a bankruptcy petition. Months later, an entity called Hightstown Enterprises, LLC paid the 4J Group for a transfer of the 4J Group’s membership interests.  Hightstown Enterprises also purchased an assignment of an unrelated loan made by Progress Direct, LLC to the LLC.  As a result of these transactions, Hightstown Enterprises was both a creditor of the LLC and the (apparent) holder of the Preferred Units that had originally been issued to the 4J Group.

After the company filed its voluntary Chapter 11 petition, Hightstown Enterprises filed a motion to dismiss.  And, after determining that the bankruptcy court could dismiss the case on its own motion whether Hightstown Enterprises had standing to seek dismissal, the bankruptcy court dismissed the case sua sponte.

In dismissing the Chapter 11 case, Judge Kaplan noted that, in Price v. Gurney, 324 U.S. 100 (1945), the Supreme Court held that the entity vested with the “power of management” has the requisite authority to file a bankruptcy case for a corporation. The Price decision further held that if a court finds “that those who purport to act on behalf of the corporation have not been granted authority by local law to institute the proceedings, it has no alternative but to dismiss the petition.” Id. at 106. A corporate bankruptcy case filed by an entity that lacks the “power of management” must be dismissed, since the filing of a petition is a specific act requiring specific authorization.

The company argued in opposition to dismissal that Hightstown Enterprises had not properly acquired the Preferred Units from the 4J Group in compliance with the requirements of the company’s LLC Agreement. Judge Kaplan rejected this argument because the company had not sought the requisite consent from either the 4J Group or from Hightstown Enterprises prior to initiating its bankruptcy case. The bankruptcy court concluded: “Regardless of who actually ‘holds’ the units in this case – Hightstown Enterprises or the 4J Group – the Debtor failed to get the requisite consent. Therefore, under the terms of the LLC Agreement, the Debtor had no authority to commence bankruptcy proceedings.”

Judge Kaplan Holds That Public Policy Considerations Do Not Override an LLC Agreement’s Provision Restricting Access to Bankruptcy Protection

There are two competing considerations in determining whether provisions of an LLC agreement that restrict authority to file a bankruptcy case are void as against public policy. A person – including a corporation and a limited liability company – has a constitutional right to file a bankruptcy case. However, a person also has a constitutional right to negotiate and enter into contracts with creditors and other stakeholders.

The Court in 3P Hightstown recognized that other decisions had found that public policy favors the ability of a company to file a Chapter 11 petition. Specifically, the Court addressed and distinguished a case authored by Bankruptcy Judge Mary Walrath for the District of Delaware.  In Judge Walrath’s case, In re Pace Industries, LLC, 2020 WL 5015839 (Bankr. D. Del. May 29, 2020), the LLC had been forced by the pandemic to terminate a large swath of its workforce and to close some facilities. To protect creditors and employees and to preserve value, Pace Industries filed a prepackaged bankruptcy petition in which the debtor’s lenders had agreed to full payment to creditors. However, the LLC agreement for Pace Industries permitted shareholders to prevent the filing of a petition, and a minority shareholder sought to exercise its blocking right and to have the case dismissed. Judge Walrath ruled that the restrictive provision in the LLC agreement was void as a violation of public policy, reasoning that minority shareholders have a fiduciary duty to creditors (when the company is in the “zone of insolvency”) and to other shareholders. Therefore, Judge Walrath concluded that the minority shareholder was bound to consider the best interests of all parties in interest prior to exercising its contractual right to block the bankruptcy filing. In short, the restrictive provision of the corporate charter was declared void because it operated to permit a minority shareholder to violate its fiduciary duty.

The 3P Hightstown opinion distinguished Judge Walrath’s decision in Pace Enterprises both factually and legally. As a factual distinction, unlike the debtor in Pace, the 3P Hightstown debtor was an investment LLC that had no employees or significant creditors who would benefit from the bankruptcy case, and the record in the 3P Hightstown case did not support a finding that the bankruptcy would benefit most stakeholders. As a legal matter, Judge Kaplan disagreed with Judge Walrath’s finding that the objecting minority shareholder in the Pace case owed a fiduciary duty to other shareholders and to creditors. Instead, Judge Kaplan found that only managing members of a Delaware LLC have fiduciary duties, and that, since there is no breach of fiduciary duty that would render the 3P Hightstown restrictive provision void as against public policy, the policy of permitting contractual freedom takes precedence. Since the bankruptcy case was filed in violation of the contractual terms of the LLC agreement, the Court dismissed the case.

Judge Kaplan also distinguished another Delaware case, which found a restrictive provision to be void as against public policy, because that case involved an agreement with an existing creditor who negotiated and obtained, as a condition of forbearance, an amendment to the debtor’s LLC operating agreement.  In In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016), Bankruptcy Judge Kevin Carey examined a forbearance agreement entered into between a limited liability company and a creditor who was granted a single common unit interest in the LLC in consideration of its agreement to forbear exercising its rights. In connection with that agreement, the LLC operating agreement was amended to include a restrictive provision requiring the unanimous consent of all common unit holders as a prerequisite to any bankruptcy filing by the LLC. The bankruptcy court held that the new restrictive provision in the LLC agreement was void as contrary to public policy because the provision was obtained as a requirement of the forbearance agreement for the sole purpose of permitting a creditor (who became a new minority equity holder) to eviscerate the right of the LLC to seek federal bankruptcy relief.

The 3P Hightstown court only briefly distinguished the Intervention Energy Holdings case by stating: “this case does not present a situation whereby Hightstown Enterprises extracted an amendment to the LLC Agreement or otherwise demanded the inclusion of a provision granting it the right to prevent bankruptcy.” 3P Hightstown at p. *5. This finding may have been worthy of more discussion, but a comparison of that case to 3P Hightstown suggest that the distinguishing facts are: (a) that Intervention Energy involved an existing creditor that effectively negotiated an unenforceable waiver from its borrower of the right to file bankruptcy, and the fact that the waiver was accomplished by way of a contemporaneous amendment to the borrower’s LLC agreement did not change the analysis; and (b) 3P Hightstown involved a relatively long-standing restrictive provision that an earlier investor (not an existing creditor) negotiated as an amendment to the LLC agreement as opposed to the context of a forbearance agreement.

Rather than specifically discussing any details of the finding that Intervention Energy involved different facts, Judge Kaplan found that the 3P Hightstown case was “strikingly analogous” to another case with similar facts.  Specifically, in In re Franchise Services of North America, Inc., 891 F.3d 198, 207 (5th Cir. 2018), as revised (June 14, 2018), the Fifth Circuit addressed facts involving an amendment to a corporate charter that was triggered by a substantial equity investment, and that effectively granted a preferred equity holder the right to veto any decision to file bankruptcy. The debtor in Franchise had reincorporated in Delaware as part of an investment, and the Fifth Circuit found that Delaware law did not affect the preferred shareholder’s right to vote against the bankruptcy petition.  The Fifth Circuit also found that federal law does not prevent a bona fide shareholder from exercising its right to vote against a bankruptcy petition just because it was also an unsecured creditor. Distinguishing Intervention Energy, the Fifth Circuit stated that there was no evidence in the Franchise case that the arrangement was merely a ruse to ensure that the debtor would pay a creditor – i.e., the preferred shareholder’s parent company.

In the Franchise case, the Fifth Circuit emphasized the fact that the creditor had made an actual equity contribution in exchange for its shares in the company and thereby distinguished its holding from the Intervention Energy case where a creditor had included or inserted a provision into a contract in exchange for a forbearance or other concession. Similar holdings include: In re Lexington Hosp. Grp., LLC, 577 B.R. 676, 679–81, 684–86, 688 (Bankr. E.D. Ky. 2017) (denying a motion to dismiss filed by a lender which conditioned financing on the grant of an equity interest and the appointment of a director who could veto bankruptcy without violating a fiduciary duty); In re Lake Mich. Beach Pottawattamie Resort LLC, 547 B.R. 899, 911 (Bankr. N.D. Ill. 2016) (denying a motion to dismiss where the lender conditioned forbearance on its appointment as a “special member” without fiduciary duties but with the right to veto a bankruptcy); In re Bay Club Partners–472, LLC, No. BR 14-30394-RLD11, 2014 WL 1796688, at *3–6 (Bankr. D. Or. May 6, 2014) (denying a motion to dismiss where the lender requested provision in operating agreement prohibiting the filing of a voluntary petition before all debts were paid in full).

Conclusion

The key takeaway from Judge Kaplan’s analysis in 3P Hightstown, and from the other analyzed therein, is that a restrictive provision may be enforceable if a new investor provides funding and becomes an equity holder with veto power over an artificial entity’s decision to file bankruptcy. On the other hand, a creditor likely will be unable to obtain an enforceable waiver of its borrower’s right to seek bankruptcy protection even if it obtains an ownership interest in the subject company. The 3P Hightstown decision should be examined by counsel and limited liability companies considering a potential bankruptcy filing. The details of any LLC agreement need to be analyzed so that a determination can be made regarding the putative debtor’s authority to file a bankruptcy case. Furthermore, counsel should advise LLCs that investors (if they are not existing creditors) who seek to add restrictive provisions as amendments to LLC agreements may be able to enforce those provisions.