Bankruptcy Panel Enforces LLC Agreement's Prohibition on Bankruptcy Filing
A Bankruptcy Appellate Panel (BAP) of the Tenth Circuit recently upheld a bankruptcy court’s dismissal of an LLC’s Chapter 11 bankruptcy petition on the ground that the LLC’s operating agreement barred the LLC from filing for bankruptcy. DB Capital Holdings, LLC v. Aspen HH Ventures, LLC (In re DB Capital Holdings, LLC), No. CO-10-046, 2010 Bankr. LEXIS 4176 (B.A.P. 10th Cir., Dec. 6, 2010). Bankruptcy law has long refused to enforce contractual prohibitions on voluntary bankruptcy filings, so this case appears to be a chink in that rule.
DB Capital Holdings, LLC was a Colorado condominium developer whose project was 14 months late and $4 million over its $82 million budget. It had no funds to continue the project and was both insolvent and in breach of its loan agreements with its principal lender. At the lender’s request, a receiver was appointed by a Colorado state court to take charge of and protect the LLC’s project.
The LLC’s two members were in disagreement over the receivership, and the LLC’s sole manager then filed a Chapter 11 bankruptcy petition on behalf of the LLC. At that point one of the members filed a motion to dismiss the Chapter 11 case, claiming that the manager lacked authority because the LLC’s operating agreement barred its bankruptcy filing. The operating agreement stated:
The Company (v) to extent permitted under applicable Law, will not institute proceedings to be adjudicated bankrupt or insolvent; or consent to the institution of bankruptcy or insolvency proceedings against it; or file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy ….
Id. at *9 (ellipsis in original). The bankruptcy court held that the LLC’s operating agreement precluded the manager from filing for bankruptcy on the LLC’s behalf and dismissed the Chapter 11 proceeding.
The BAP began its analysis by noting 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,” and that bankruptcy courts must look to state law to resolve authority issues. Id. at *7. Under the Colorado LLC Act, an LLC’s operating agreement governs the rights and duties of an LLC’s members and managers. Id. The operating agreement language was clear; it expressly barred the LLC from filing a bankruptcy petition.
The manager contended that the operating agreement’s ban on filing a petition was invalid because it had been executed at the creditor’s request and only benefited the creditor. The manager cited numerous cases holding that contractual prohibitions on filing for bankruptcy are unenforceable.
The court distinguished those cases as involving debtor agreements with third parties. “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 against public policy, nor has the court located any.” Id. at *10. The court found the express restriction on the filing of a bankruptcy petition to be enforceable.
The court also reviewed provisions of the LLC’s operating agreement that required the manager to carry out the LLC’s business “as presently conducted,” and that barred the manger from doing any act that would make it impossible to carry on the ordinary business of the LLC. The court concluded that even without the operating agreement’s express prohibition on filing a petition, the provisions relating to the ordinary business of the LLC, as presently conducted, prohibited the manager from filing a bankruptcy petition.
Although the court upheld the operating agreement’s express bar on any bankruptcy filing by the LLC, it qualified its opinion in a way that introduced some uncertainty about the scope of its opinion:
In addition, Debtor does not point to any record evidence that the May amendment was coerced by a creditor. For that reason, the Court declines to opine whether, under the right set of facts, an LLC’s operating agreement containing terms coerced by a creditor would be unenforceable.
Id. at *10. It’s the word “coerced” that makes one blink. Normally the only reason an LLC agreement would include a prohibition on bankruptcy filings would be that a creditor or some other third party requested it. If “coerced” means that the limitation was put in the LLC agreement at the request of a creditor, this case won’t have much impact.
“Coerced” usually means some undue pressure or threat. Often some element of physical force is involved, which presumably was not the court’s meaning. Is the LLC coerced if a lender offers a loan on terms that require the LLC to include the restriction in its operating agreement? Most lawyers would probably say no, that’s not coercion. Perhaps the court had in mind the type of situation where a company is desperate for a loan and lacks bargaining power.
Assume the bankruptcy courts will generally enforce these restrictions, as the BAP did this case. Can a lender rely on such a restriction in an LLC’s operating agreement? Not standing alone – the operating agreement is an agreement between members, so the members can change their agreement and eliminate the restriction. For the lender to rely on the restriction the lender would need a way to limit the members’ ability to amend the agreement. For example, the lender could be a member or have a representative that would serve as a member, and vote against elimination of the restriction.
A better way, at least if the debtor is a Delaware LLC, may be to rely on Section 18-101(7) of the Delaware LLC Act. That section states: “A limited liability company agreement may provide rights to any person, including a person who is not a party to the limited liability company agreement, to the extent set forth therein.” A Delaware LLC agreement could provide that it could not be amended without the consent of a named third party, such as the lender.
Washington Dismisses Lawsuit by Cancelled LLC and Denies Award of Attorneys' Fees to Defendant
Washington’s Court of Appeals has issued another opinion dealing with the impact on litigation of the cancellation of an LLC’s certificate of formation. Metco Homes, LLC v. N.P.R. Constr., Inc., No. 64535-8-I, 2010 Wash. App. LEXIS 2428 (Wash. Ct. App. Nov. 1, 2010) (unpublished).
Metco was a construction contractor and developed a condominium project in Everett. N.P.R. was Metco’s subcontractor and installed the project’s siding. The siding leaked, Metco sued N.P.R., and before trial Metco’s certificate of formation was administratively cancelled by the Washington Secretary of State. On N.P.R.’s motion the trial court dismissed Metco’s suit and awarded attorneys’ fees to N.P.R. based on the attorneys’ fees clause in their contract.
The Metco case is part of the progeny of Chadwick Farms Owners Association v. FHC, LLC, 166 Wn.2d 178, 207 P.3d 1251 (2009), which I previously reviewed, here. Chadwick Farms held that once a Washington LLC’s certificate of formation has been cancelled, it cannot sue or be sued and any pending lawsuits by or against the LLC abate.
An unusual aspect of Metco is the timing of Metco’s cancellation and the maneuvering of the trial date by N.P.R.’s counsel. Metco was administratively dissolved by the Washington Secretary of State on June 1, 2006, apparently for failing to file its annual report and pay its annual fee. Under the LLC Act then in effect, its certificate of formation was due to be cancelled two years later, on June 1, 2008. Metco’s trial date was originally set for trial on May 5, 2008, at which time its certificate of formation would not yet have been cancelled.
Metco was apparently unaware of its dissolution and impending cancellation. That’s odd, because the Secretary of State sends several notices to the registered agent of an LLC that fails to renew its annual report. But N.P.R.’s counsel was well aware of the impending cancellation.
As alleged by Metco, N.P.R.’s counsel misrepresented a scheduling conflict and successfully importuned Metco to reschedule the trial to a later date, after June 1, 2008. Simultaneously she was drafting motion papers to dismiss Metco’s suit on grounds of cancellation of its certificate of formation (which would not happen until June 1). After Metco was cancelled on June 1, she filed N.P.R.’s motion for dismissal of Metco’s lawsuit.
The Court of Appeals found the allegations regarding N.P.R.’s counsel to be disturbing, if true. Metco, 2010 Wash. App. LEXIS 2428, at *8. But even if true, said the court, reinstatement of Metco’s lawsuit would not be required.
[I]t is simply inaccurate to say the alleged deception “caused” the cancelation. Regardless of the alleged actions of NPR’s counsel, Metco could have renewed the LLC at any time in the two years after it was administratively dissolved. Under these circumstances, the trial court’s decision was neither untenable nor was it based on an incorrect standard of law. The trial court did not abuse its discretion in denying the motion to vacate.
Id. Because N.P.R. prevailed at trial, the trial court awarded N.P.R. its attorneys’ fees against Metco, pursuant to the attorneys’ fees clause in their contract. The Court of Appeals reversed and rather straightforwardly applied Chadwick Farms. “[A] lawsuit to enforce contractual duties owed by a LLC, including a duty to pay attorney fees and costs, cannot be maintained after the LLC has been cancelled.” Id. at *8-9.
The court’s emphasis on Metco’s ability to avoid cancellation by simply filing its annual report and paying the fees, and the court’s unwillingness to reinstate the lawsuit even if misrepresentation by the defendant’s counsel were to be established, show the draconian results of the Chadwick Farms ruling. Fortunately, the relevant provisions of Washington’s LLC Act have since been amended to eliminate the possibility of cancelling an LLC’s certificate of formation. I previously described those changes, here.
Washington LLCs: Dissenters' Rights and Attorneys' Fees
The Washington Supreme Court recently reversed a trial court and Court of Appeals decision on an award of attorneys’ fees to an LLC dissenter. Humphrey Indus., Ltd. v. Clay St. Assocs., LLC, No. 82687-1, 2010 Wash. LEXIS 1004 (Wash. Nov. 10, 2010). The Humphrey case stands out because there are so few reported cases on LLC dissenters’ rights, and because the five-to-four decision required the LLC to comply strictly with the statute’s 30-day period for paying the dissenter the value of its LLC interest. Clay Street Associates, LLC was formed in 1997 to hold a single real estate property. In 2004 most of the members decided to approve a sale of the property. The LLC agreement required unanimous member approval, and member Humphrey Industries, Ltd. refused to approve the sale. Circumvention of Unanimity. The other members then eliminated the unanimity requirement by approving a merger of the LLC into a new LLC that did not require unanimity for a sale of the property. (Unless the LLC agreement provides otherwise, a merger requires the approval of only a majority of the member interests, measured by their capital contributions to the LLC. RCW 25.15.400.) Members have the right to dissent from a merger of a Washington LLC and obtain the fair value of their member interest in cash. RCW 25.15.430. Humphrey exercised its dissenter’s right and demanded the fair value of its LLC interest. Dissenters’ Rights. Dissenters’ rights, sometimes called appraisal rights, originated with corporations: Essentially, an appraisal is the method of paying shareholders for taking their property; it is the statutory means whereby shareholders can avoid the conversion of their property into other property not of their choosing and is given to shareholders as compensation for the abrogation of the common-law rule that a single shareholder could block a merger. The purpose of these statutes is to protect the property rights of dissenting shareholders from actions by majority shareholders that alter the character of their investment. 12B William Meade Fletcher, Fletcher Cyclopedia of the Law of Corporations § 5906.10, at 386-87 (rev. vol. 2009) (footnotes omitted). Some but not all of the states have provisions for dissenters’ rights in their LLC Acts. For example, besides Washington, California, Florida, Minnesota, and New York have statutory provisions for LLC dissenters’ rights. Delaware’s LLC Act has no provision for dissenters’ rights, but it authorizes an LLC’s operating agreement or a merger agreement to provide contractual appraisal rights. DLLCA § 18-210. The Merger. The LLC’s merger became effective December 7, 2004. The LLC was required by the statute to pay Humphrey the fair value of its member interest within 30 days, RCW 25.15.460(1), but the LLC lacked funds. It proceeded to sell the real estate, and on May 27, 2005 paid Humphrey its estimate of the fair value of Humphrey’s member interest as of the merger date, plus interest. Humphrey disputed the LLC’s valuation and demanded a larger amount. Litigation ensued, the LLC made a settlement offer, settlement talks broke off, and the litigation went to trial. The trial court found that the LLC had undervalued Humphrey’s interest and ordered the LLC to pay Humphrey an additional $60,588. Attorneys’ Fees. Then the parties argued over attorneys’ fees. The statute says that in a proceeding over the valuation of a dissenter’s member interest, the court may assess attorneys’ fees and expert fees: (a) Against the limited liability company and in favor of any or all dissenters if the court finds the limited liability company did not substantially comply with the requirements of this article; or RCW 25.15.480(2). These provisions are similar to those in the Model Business Corporation Act and in many state corporate statutes. E.g., RCW 23B.13.310. Trial Court Ruling. The trial court found that the LLC had violated the Act by not paying Humphrey for its interest within 30 days of the merger as required by RCW 25.15.460(1). But, said the court, the LLC had “substantially complied” because it lacked the funds to pay, moved expeditiously to sell the real estate to generate funds to pay Humphrey, and paid interest on the delay period. Further, the trial court found that Humphrey acted arbitrarily, vexatiously, and not in good faith in pursuing its dissenters’ rights claim. It therefore awarded attorneys’ fees and expenses to the LLC. Humphrey appealed and the Court of Appeals affirmed. Supreme Court Weighs In. The Washington Supreme Court in Humphrey saw the 30-day payment requirement differently. The court characterized the purpose of the 30-day requirement as ensuring that dissenters have immediate use of the money which the LLC estimates to be the value of their member interests. Humphrey, 2010 Wash. LEXIS 1004, at *13-14. Humphrey should have received payment within 30 days of the merger date; instead the LLC sent the funds almost six months later. “A six-month deferral of payment is not ‘substantial compliance’ with a statute that unambiguously requires payment ‘within thirty days.’” Id. at *17. The court therefore reversed the Court of Appeals’ determination that the LLC had substantially complied with the LLC Act, and remanded to the trial court to determine whether Humphrey should be awarded attorneys’ fees based on the LLC’s noncompliance with the Act’s 30-day payment requirement. Id. at *20. The court also reversed the award of attorneys’ fees to the LLC. The trial court had concluded that Humphrey had acted arbitrarily, vexatiously, and not in good faith, based on its refusal to accept a settlement offer that would have provided more to Humphrey than it received from the trial court’s valuation award, and based on Humphrey’s conduct in other lawsuits against the LLC. The Supreme Court pointed out that evidence of conduct or statements in settlement negotiations is not admissible to prove the validity or invalidity of a claim or its amount. The court opined that even if the evidence was admitted for a permissible purpose, the record did not establish that Humphrey’s actions were arbitrary, vexatious, or in bad faith. Id. at *21. Ill-Motivated Merger. In a strange aside, the court stated: “If any acts were in bad faith, they were committed by the other members of Clay Street, who sought to bypass the dissenters’ rights statute and section 8.1 of their own LLC Agreement, which specifies that the property ‘shall not be sold, conveyed, and/or assigned without the mutual consent of each of the members.’” Id. at * 21-22 (ellipsis omitted). But after all, the members’ agreement did not require unanimous approval of a merger, and the LLC Act allows the surviving LLC to have different terms in its operating agreement. Where’s the bad faith in taking action allowed by the statute and the LLC agreement, in order to sell an asset and distribute the net proceeds to the members as their interests lie? Delaware’s doctrine of independent legal significance, DLLCA § 18-1101(h), would support the validity of using a merger to eliminate a unanimous voting requirement, but Washington’s LLC Act has no such provision. Holding. The court therefore reversed the trial court’s award of attorneys’ fees against Humphrey, and remanded for consideration of whether, in light of the LLC’s failure to substantially comply with the Act, Humphrey is entitled to attorneys’ fees. Dissent. The dissent contended that the legislature would have been well aware that in some cases 30 days is a short time to accomplish the accounting, appraisal, and other steps required to accomplish a merger and transfer property and assets, and that therefore the legislature must have intended the “substantial compliance” requirement to apply to the 30-day payment period as well as to the other provisions of the dissenters’ rights section. Humphrey, 2010 Wash. LEXIS 1004, at *26-27 (Chambers, dissenting). The majority riposted in a footnote that prudent planning is the answer: “It is likely that the legislature chose 30 days assuming that merging business entities would have the prudence and good faith to lay the groundwork for selling property well before a merger became effective, or seek other financing, so as to meet the statutory requirement.” Id. at * 18 n.11 (majority opinion). Lessons. The obvious lesson for any Washington LLC planning a merger is that if any members dissent, the LLC must be prepared to pay the dissenting members the fair value of their interests within 30 days of the later of the date the merger becomes effective or the date the member’s payment demand is received. The other lesson is a cautionary note for drafters of LLC agreements. A requirement that all members consent before specified actions are taken is not adequate unless mergers also require unanimous consent. The LLC agreement in Humphrey did not require unanimity for a merger, and the LLC was therefore able to merge and eliminate the unanimous voting requirement. A member resisting a unanimous vote will have dissenters’ rights if the LLC uses a merger to get around the voting requirement, but that may be small consolation to the dissenting member.
(b) Against either the limited liability company or a dissenter, in favor of any other party, if the court finds that the party against whom the fees and expenses are assessed acted arbitrarily, vexatiously, or not in good faith with respect to the rights provided by this article.
