Who Gets to Play the Bankruptcy Card Under Your LLC Agreement?

June 03, 2019

If you’re a member of a multi-member LLC, and especially if it’s manager-managed, here’s a reason you might want to check under the hood of your LLC agreement: if the business goes belly up amidst squabbling or worse among the members and managers, to whom does the LLC agreement give authority to file for bankruptcy? The members? The managers? A majority of the managers or just one?

These are not just theoretical questions, having been the focus of a very recent decision by a federal district court, affirming a bankruptcy judge’s dismissal of a Chapter 11 bankruptcy filing on behalf of an LLC made by one of three managing members over the objection of the other two, in Catalyst Lifestyles Sport Resort, LLC v Sherrard, Opinion and Order, 2:18-CV-302-HAB [U.S. Dist. Ct. N.D. Ind. May 22, 2019].

The Catalyst case lies at the intersection of business divorce and bankruptcy law. The court’s opinion doesn’t describe the nature of Catalyst’s business, only that it is a member-managed Indiana LLC formed in 2015; that it has one 50% member (Tony) and two additional members (Josh and Todd) holding the remaining 50%; and that Catalyst’s downfall was due “at least in part” to conflict among the members that eventually resulted “in a flurry of court filings” beginning in 2017.

Tony filed the first state court lawsuit for injunctive relief after he was removed from the company’s bank account. Todd then filed a state court petition for judicial dissolution of Catalyst in which he alleged that the company was insolvent and could no longer operate because Tony refused to work with the other managers.

Two months later, without Todd’s or Josh’s consent, Tony filed Chapter 11 bankruptcy on Catalyst’s behalf. Presumably the filing of the bankruptcy petition automatically stayed the state court lawsuits. Todd and Josh then moved to dismiss the bankruptcy case, arguing that Tony lacked authority to file it on his own. Following an evidentiary hearing, the bankruptcy court granted the motion and dismissed the case. Tony then appealed to the U.S. District Court.

The Operating Agreement

The District Court’s opinion anchors its analysis where you would expect: Catalyst’s operating agreement, which, the court states, “must be the primary source of the authority, or lack thereof, for [Tony] to direct the filing of Catalyst’s bankruptcy.”

The court then lines up the provisions in Catalyst’s operating agreement allocating authority between the members and the managers (who happen to be the same individuals, but that’s beside the point):

• Section 5.1 provides that the LLC shall be run by the managers who will have “full and complete authority . . . to make all decisions” regarding the business, affairs, and properties of Catalyst except where control is expressly vested in the members.
• Section 5.1 also provides that any one of the three managers is authorized “to take any action permitted to be taken by the Managers” unless otherwise “expressly required pursuant to this Operating Agreement or the Act.”
• Sections 5.3 and 6.4 require the managers to obtain the approval of members holding at least 75% of the membership interests for any “sale, exchange or other disposition of all, or substantially all, of the Company’s assets which is to occur as part of a single transaction or plan” (italics added).

Since the filing of bankruptcy falls within “the full and complete authority, power and discretion to manage and control the business, affairs and properties” under Section 5.1, the court reasons, Tony could unilaterally file Chapter 11 unless such filing qualifies as a “disposition” of Catalyst’s assets under Sections 5.3 and 6.4 requiring supermajority member approval.

Did Filing Chapter 11 “Dispose” of Catalyst’s Property?

The bankruptcy judge had found that Tony’s filing of the Chapter 11 petition disposed of Catalyst’s property by transferring “all legal and equitable interests” to the bankruptcy trustee under 11 U.S.C. § 541, and therefore dismissed the petition since its filing required supermajority member approval.

In opposing Tony’s appeal, Todd and Josh relied on In re Mid-South Business Associates, LLC, 555 B.R. 565 [Bankr. N.D. Miss. 2016], a remarkably similar case testing the authority of one of several LLC managing members to file for bankruptcy on his own where the operating agreement required two-thirds member approval for any “sale, exchange, or disposition” of the LLC’s property. The bankruptcy judge in Mid-South dismissed the petition on application by the other members on the basis that the filing constituted a “disposition” of the LLC’s property by way of transfer to the trustee under Section 541, thereby requiring two-thirds member approval.

The District Court in Catalyst, however, noted one important difference between Catalyst and Mid-South: the former involves a Chapter 11 reorganization, while Mid-South involved a Chapter 7 liquidation. As the District Court explained, citing several dictionary definitions of “dispose” which I’ve omitted:

The Court could certainly conclude that the court in Mid-South and the Bankruptcy Court below failed to apply the plain and ordinary meaning of “dispose,” as is required under Indiana law. Regardless of the definition one chooses, “dispose” or “disposition” has a connotation of finality. The disposition of property, then, is not a temporary act; it is the final, conclusive relinquishment of the property.

It is the finality requirement that arguably makes the disposition of property a poor fit with the Chapter 11 process. As noted by the Bankruptcy Court, Catalyst filed the Bankruptcy Petition “in a purported attempt to reorganize,” not to “liquidate them.” (ECF No. 10-2 at 20-21) (distinguishing between Chapter 7 and Chapter 11 bankruptcy). A debtor in a Chapter 11 proceeding is generally a “debtor in possession”; i.e., it remains in possession of the assets and has many of the rights and duties of a trustee. 11 U.S.C. § 1107(a). Pursuant to Section 1108 of the Code, debtors in possession are automatically given leave, standing in the place of a Trustee pursuant to Section 1107, to operate their businesses after the filing of the Chapter 11. Thus, while Section 541 may transfer legal title to the trustee, from a day-to-day standpoint little changes upon the filing of Chapter 11 bankruptcy. (Citation omitted.)

The District Court’s opinion further emphasizes, quoting from 11 U.S.C. § 1141, that in a Chapter 11 reorganization, “the property dealt with in the plan is returned to the debtor ‘free and clear of all claims and interests of creditors, equity security holders, and of general partners in the debtor.’”

If that’s as far as you got with the court’s opinion, you couldn’t be faulted for predicting the court’s reversal of the Bankruptcy Court’s decision and the reinstatement of the Chapter 11 petition on the ground that Tony’s filing, unlike the Chapter 7 filing in Mid-South, does not involve a “disposition” of Catalyst’s property under the exception to broad managerial authority in Sections 5.3 and 6.4 of Catalyst’s operating agreement.

But you’d be wrong. “While this Court may not have found that the filing of the Chapter 11 bankruptcy constituted a disposition of the property,” the court wrote, “the Court cannot find that the Bankruptcy Court’s finding to the contrary was so unreasonable that it constituted an abuse of discretion.”

The court gave two reasons for its turnabout. First, “to the extent the language in the Operating Agreement is ambiguous, a reasonable construction of the language could be derived from the absence of the word ‘bankruptcy’ from Sections 5.3(f) and 6.4.” The word bankruptcy appears in the agreement’s withdrawal provision and, the court reasoned, could just as easily been included in Section 5.3 and 6.4. “[P]erhaps the parties intended the omission,” the court wrote.

Second, and related to the first, courts are required to “interpret the contract as written, not as it might have been written.” As the court explained,

[T]he Operating Agreement might have been written to expressly include bankruptcy in the list of actions requiring the approval of a member supermajority. This certainly would have been the preferred course. However, it was not unreasonable for the Bankruptcy Court to have found that, despite the lack of specific reference to bankruptcy in the supermajority requirements, the filing of a Chapter 11 bankruptcy constituted a disposition of property requiring approval of a supermajority.

Check Your LLC Agreement

Although business divorce litigation usually does not involve insolvent companies, Catalyst illustrates how a bankruptcy filing can serve as a weapon in a battle among the LLC members when they cannot agree on the winding up of the LLC’s business and/or the liquidation of its assets.

It’s interesting to note the court’s description of the operating agreement in Catalyst as “poorly written” and part of an “off-the-shelf” “LLC kit.” The court also commented on the lack of member involvement with its drafting, “resulting in a disconnect between what the members wanted and what the plain language of the Operating Agreement provided.” I would wager countless other operating agreements have come about in similar fashion in every jurisdiction.

As I’ve warned elsewhere, the use of off-the-shelf, fill-in-the-blank operating agreements is risky business. I suspect the form used in Catalyst borrowed the language, “sale, exchange, or other disposition of all, or substantially all” the LLC’s assets, from traditional business corporation statutes requiring board and shareholder approval for such transactions and triggering dissenting shareholder rights, as found in Article 9 of New York’s Business Corporation Law.

The irony is, LLC statutes (or at least the ones I’ve looked at including New York’s LLC Law) don’t include that particular feature of business corporation statutes as a default rule, much less as a mandatory rule, leaving it instead to such devises as the members see fit to include in the operating agreement.

The decision to file for bankruptcy is existential in the case of Chapter 7 and potentially existential in the case of Chapter 11. I think most would agree, absent unusual circumstances a decision of that magnitude is best not left to a single managing member holding a minority interest in the LLC, and should require at least majority consent of the equity holders.

Members of multi-member LLCs and lawyers who draft operating agreements therefore should check their operating agreements and forms to be sure that the authority to file a bankruptcy petition of any sort requires an appropriate level of manager and member approval.