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LLC’s, Creditors and Authority to File Bankruptcy

LLC’s, Creditors and Authority to File Bankruptcy

November 20, 2017
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Limited liability companies (LLC’s) are the entity of choice these days for small, medium and even huge (think General Motors) businesses.  Laws governing the operation of LLC’s vary from state to state, but tend to offer owners greater flexibility and control than for other entities. LLC’s can be managed by the members, or by managers. Owners are “members” and membership rights consist of both management rights and economic rights. Much like large investors in a company may gain a seat on a board of directors, investors and lenders to LLC’s may seek membership status or even the right to appoint a manager for the company. For years, lenders have insisted on membership status, changes in operating agreements or manager appointments to try and prevent owners of LLC’s from filing bankruptcy.  Does that work?

Each situation is different and depends on the applicable law and specific facts, but a Kentucky bankruptcy judge recently decided “No”, such steps could not prevent an LLC from filing bankruptcy.  The case is Lexington Hospitality Group, LLC (“LHG”), Case No. 17-51568 in the Bankruptcy Court for the Eastern District of Kentucky.[1]  LHG was organized in May, 2015 and it was managed by Janee Hotel Corporation (“Janee”) under the original operating agreement.  The operating agreement gave the manager full authority to operate the business in the ordinary course, but member approval was needed to change business operations, admit a new member or engage in conflict of interest transactions. The original operating agreement did not address authority to file bankruptcy.

In September, 2015, LHG acquired a hotel, borrowing $6,000,000 of the purchase price with a loan secured by a mortgage and security agreement against the assets of the hotel. LHG also amended its operating agreement to admit a new member – an entity created and owned by the lender that would have a 30% membership interest until the loan was repaid.  Two other 5% members were admitted, so Janee retained a 60% membership interest and remained the manager of LHG.  The amended operating agreement had one new provision which limited the authority to file bankruptcy to an “independent manager,” who had to get approval of 75% of the members. The independent manager position also ended when the loan was repaid. Another new provision required LHG to get written votes from the lender and all members before filing bankruptcy. LHG defaulted and in February, 2017, an addendum to the operating agreement provided that an additional 20% membership interest was transferred to the lender/member, resulting in a 50% ownership stake[2].  LHG defaulted again, the lender filed suit and asked for the appointment of a receiver, and LHG filed bankruptcy in August, 2017.  Neither the independent manager, nor 75% of the members authorized the filing, but it was authorized by Janee as the company manager.

Ruling on the lender’s motion to dismiss the case as an unauthorized filing, the Bankruptcy Court first determined that state law controlled how a company may authorize filing bankruptcy, but federal law controlled whether provisions restricting that authority were valid.  The Court ruled that the provisions restricting the ability to file bankruptcy were not valid because they were intended to take control of the decision away from LHG and place it in the hands of the lender, and for no other legitimate reason.  The Court found that giving up the right to file bankruptcy through a contract was not permissible under federal law.  That left the issue of whether the rest of the operating agreement or state law authorized LHG’s manager to file bankruptcy.

The Court analyzed the remaining provisions of the operating agreement and Kentucky law to decide that Janee, as manager, did have authority to file the bankruptcy.  First, the operating agreement gave the manager authority to manage the business and affairs of LHG unless there was a restriction elsewhere in the operating agreement.  While there were restrictions on decisions such as admitting new members, once the lender’s provisions were invalidated, there were no restrictions on filing bankruptcy.  In addition, the Court found that Kentucky law gave managers exclusive power to manage the business and affairs of a company unless the operating agreement or other laws restricted that authority. Kentucky law does not require unanimous member consent to authorize a bankruptcy filing. Ultimately, the Court decided that bankruptcy might be outside the “ordinary course” of business, but it was a decision that was part of the business affairs of LHG.  The Court denied the lender’s motion to dismiss and found that LHG’s bankruptcy filing was properly authorized.

This ruling is important because it offers guidance to attorneys who represent lenders, businesses in financial trouble, and those who form and help govern limited liability companies.  What if a lender did not become a member, but just insisted on a provision that required a unanimous member vote to file bankruptcy? What if the operating agreement already had a unanimous member vote requirement to file bankruptcy before a loan was acquired and the lender took a 1% member interest?  Each case is unique, and should be reviewed by knowledgeable counsel.  But just because a lender insists on bankruptcy restrictions and a membership stake as a condition of a loan doesn’t mean the doors to the Bankruptcy Court are closed.

See below link for the full opinion:

85_Memorandum_Opinion

[1] Full disclosure, DelCotto Law Group represents Lexington Hospitality Group.

[2] Additional restrictions were contained in the second addendum which are omitted for brevity.