Contrary to holdings by the Delaware Chancery Court, Bankruptcy Judge Christopher M. Lopez of Houston held that Delaware law cannot strip away a member’s managerial and voting rights in a limited liability corporation when the member files a chapter 11 petition.
The chapter 11 debtor was a corporation that held a 25% interest in an LLC. Under the management agreement, the debtor held two of five board sets. The management agreement provided that the board could not take certain actions without the consent of at least one of the debtor’s board members.
After the debtor filed a chapter 11 petition, the other two members of the LLC invoked Section 18-304 of the Delaware Limited Liability Company Act. It provides that “a person” ceases to be a member of an LLC when that person files bankruptcy voluntarily. “Person” under Delaware law includes a corporation like the debtor.
Using Section 18-304, the other two members changed the management agreement to say that the debtor no longer held a voting or managerial interest in the LLC. They acted without consent from either of the debtor’s board members.
The debtor responded by filing a motion in bankruptcy court seeking a declaration that the action violated the automatic stay. The other two members opposed, contending that the action was permissible under Delaware law and that the dispute was subject to an arbitration clause contained in the management agreement.
Arbitration
In his December 12 opinion, Judge Lopez first dealt with arbitration, observing that “the existence of an arbitration clause in an agreement doesn’t mean it is automatic.” He cited the Fifth Circuit for the proposition that a bankruptcy court may decline to enforce an arbitration agreement involving a proceeding that “derives exclusively” from the Bankruptcy Code.
Judge Lopez admitted that the LLC management agreement contained a valid arbitration clause, but, he said, “this is not a contract dispute that should be arbitrated. There is nothing in the LLC Agreement to interpret.” Rather, he said that the other members were relying on Delaware corporate law for the idea that the debtor lost its voting and managerial interests.
As a result, Judge Lopez said there is a “direct conflict between § 541 of the Bankruptcy Code and Delaware law,” making it “as core of a proceeding as it gets in bankruptcy.” He denied the motion to compel arbitration because the stay violation motion was a core proceeding and permitting arbitration would be “inconsistent with the purpose of the Bankruptcy Code.”
The Conflict with State Law
The other members of the LLC claimed there was no stay violation because the debtor’s loss of voting and managerial rights resulted from state law. Indeed, Judge Lopez cited decisions from the Delaware Chancery court holding that Section 18-304 is not preempted by the Bankruptcy Code and that a debtor retains its economic interest but automatically loses voting and managerial rights.
Judge Lopez observed that the Delaware courts had not dealt with the language in Section 541(a)(1), which creates an estate on filing that retains “all legal or equitable interests of the debtor in property as of the commencement of the case.” Finding a direct conflict between Section 541(a) and Section 18-304 of the Delaware Limited Liability Company Act, he said that “parties cannot contract around what becomes estate property, and states cannot legislate estate property away.”
Judge Lopez also found a direct conflict with Section 541(c)(1)(B), which includes property in a bankruptcy estate “notwithstanding any provision in an agreement . . . or applicable nonbankruptcy law . . . (B) that is conditioned on the insolvency . . . of the debtor [or] on the commencement of a case under this title.”
Judge Lopez said that his decision “clarifies that a member of a Delaware LLC who starts a bankruptcy case keeps all legal and equitable interests in the LLC that it held as of the commencement of the case.” [Emphasis in original.] He went on to say that “[m]anagerial and voting rights are legal and equitable interests that [the debtor] held as of the petition date, so they are included as property of its estate.”
Judge Lopez cited decisions from a district court in New York and bankruptcy courts in West Virginia and Oregon for reaching the same conclusion about similar state laws.
Finding a direct conflict, Judge Lopez held that Section 18-304 must “give way” to Section 541. He found a violation of the automatic stay and voided the amendment to the management agreement that had been made by the other two members.
Contrary to holdings by the Delaware Chancery Court, Bankruptcy Judge Christopher M. Lopez of Houston held that Delaware law cannot strip away a member’s managerial and voting rights in a limited liability corporation when the member files a chapter 11 petition.
The chapter 11 debtor was a corporation that held a 25% interest in an LLC. Under the management agreement, the debtor held two of five board sets. The management agreement provided that the board could not take certain actions without the consent of at least one of the debtor’s board members.
After the debtor filed a chapter 11 petition, the other two members of the LLC invoked Section 18-304 of the Delaware Limited Liability Company Act. It provides that “a person” ceases to be a member of an LLC when that person files bankruptcy voluntarily. “Person” under Delaware law includes a corporation like the debtor.