Bankruptcy Judge David D. Cleary of Chicago wrote a manual on how an LLC can be made “bankruptcy remote” without offending the notion that restricting the right to file bankruptcy or impeding the exercise of fiduciary duties is unenforceable as a violation of public policy.

The debtor was a Delaware LLC that owned a seven-story apartment building with a $30 million mortgage. The term sheet with the lender required the project to be bankruptcy remote by having one independent director acceptable to the lender. The individual selected to be the independent director also served as an independent director or manager of more than 500 entities.

The LLC agreement called for a board of two managers, one of whom was the independent director. The agreement provided that the board could not make major decisions like filing bankruptcy without the unanimous consent of the directors, including the independent director.

The mortgage matured and wasn’t paid, an event of default. The day before a hearing on the lender’s mortgage foreclosure action, the LLC filed a chapter 11 petition. Alongside the petition, the debtor’s manager stated under oath that he was authorized to file the petition.

After filing, the debtor, the debtor’s manager and the debtor’s member filed a consent to the filing of chapter 11 in lieu of meeting.

The lender filed a motion to dismiss the petition, contending that the filing was not authorized. In the ensuing hearing, the independent director testified that she was unaware of the filing, did not sign the consent and did not authorize the filing. In fact, the independent director was unaware of the chapter 11 case until she was given a subpoena to testify on the dismissal motion.

Judge Cleary’s January 6 opinion is replete with details about the debtor’s excuses for not having the consent of the independent director.

The Petition Wasn’t Authorized

Judge Cleary was tasked with deciding whether there was “cause” for dismissal under Section 1112(b). Citing the Supreme Court alongside a decision by Delaware Bankruptcy Judge Craig T. Goldblatt, he said, “There is cause to dismiss a case if corporate authority to file for relief under the Bankruptcy Code does not exist.”

Before turning to the question of whether the lender impermissibly restricted the debtor’s right to bankruptcy relief, Judge Cleary analyzed whether the petition was authorized.

Judge Cleary characterized the LLC agreement as providing that the “Debtor cannot file or consent to the filing of a bankruptcy petition without the unanimous written consent of its members and managers, including the Independent Manager.” From the evidence at trial, he said it was “clear that [the] Debtor . . . filed the Petition without first obtaining the Independent Manager’s consent.”

Judge Cleary went on to make findings of fact to the effect that the independent manager never consented to, ratified or acquiesced in the filing.

No Violation of Public Policy

The debtor argued that the lender had impermissibly prevented the debtor from having bankruptcy relief. True, Judge Cleary said,

Provisions in corporate organization documents that restrict an entity’s ability to file a bankruptcy petition or impede the ability to exercise fiduciary duties in furtherance of evaluation and authorization of a bankruptcy case are against public policy.

“Provisions that place an independent manager on the board of a limited liability company, with requirements that the independent manager must participate in certain corporate decisions, such as the filing of a bankruptcy petition, are not presumptively void,” Judge Cleary said. In other words, an operating agreement is enforceable if it “creates a structure in which a director’s fiduciary duties are respected and that complies with non-bankruptcy statutes or law.”

Judge Cleary noted how the LLC agreement required the members and the LLC to consider the interests of the members and the company. He also noted how the LLC agreement said that “‘the Independent Manager shall, in exercising their rights and performing their duties under this Agreement, have a fiduciary duty of loyalty and care similar to that of a director of a business corporation’ under Delaware law.”

Furthermore, Judge Cleary found that the “LLC Agreement requires the Independent Manager to consider Debtor’s interest when voting on whether to file for relief under the Bankruptcy Code.” In sum, he concluded that the “LLC Agreement imposed fiduciary duties upon [the independent manager], and those obligations extended to the Debtor and its Constituent Members.”

Judge Cleary found “that Debtor’s corporate documents did not impermissibly restrict its right to file for relief under the Bankruptcy Code.” Given the lack of consent by the independent managers, he ruled that the debtor did not have authorization to file the petition. Therefore, he granted the motion to dismiss.

No Bar to Refiling

Beyond dismissing, the lender wanted Judge Cleary to impose a bar to refiling. He declined.

Barring another filing, Judge Cleary said, “would effectively prohibit the Debtor from deciding — properly, in compliance with the LLC Agreement — whether or not it should file for relief under the Bankruptcy Code.”

The independent manager had resigned after learning that the petition had been filed without her consent. When a new independent manager is in place, “that independent manager should be able to act in accordance with his or her duties and determine whether to consent to the filing of a new bankruptcy case,” Judge Cleary said.

Note: The debtor is appealing the dismissal.