On May 6, 2014, the US Bankruptcy Court for the District of Oregon held, in In re Bay Club Partners-472, LLC, that a restriction on the right to file for bankruptcy protection, included in a limited liability company's (LLC) operating agreement at the insistence of its secured lender, operated as a bankruptcy waiver and therefore was unenforceable as a matter of public policy (No. 14-30394, (Bankr. D. Or. May 6, 2014)).

Bay Club Partners-472, LLC (Debtor) was formed as a manager-managed LLC organized under the laws of Oregon to purchase, renovate and operate a large apartment complex located in Arizona (Property). Legg Mason Real Estate CDO I, Ltd. (Lender) loaned the Debtor funds to acquire the Property.

The Debtor's operating agreement conferred broad authority on its manager (Manager) to conduct its business affairs, both in and outside of the ordinary course of business. However, at the Lender's request, it also contained a provision that limited the Debtor's right to file for bankruptcy protection until the Lender's debt was repaid in full (Restriction).This provision was apparently included in the operating agreement without discussion among the members, and not in the loan documents, where it typically would appear.

The loan terms were modified four times. In early 2014, negotiations concerning further forbearance and modification of the loan broke down. On January 17, 2014, the Lender sent the Debtor a notice of default and offset all of the funds in the Debtor's bank account against the unpaid balance of the loan. Despite the Restriction, on January 28, 2014, the Manager filed a Chapter 11 petition for the Debtor, which was signed by three of the Debtor's four members. The Lender moved to dismiss the proceeding, citing the Restriction and arguing that the unanimous consent of all of the Debtor's members was required to file a bankruptcy case.

The Court rejected the Lender's arguments, holding that the Restriction operated as a waiver of the right to file for bankruptcy protection and therefore it was void as a matter of public policy. In addition, the Court held that the Manager had the authority to file a Chapter 11 case without the unanimous consent of the Debtor's members.

First, the Court noted that the issue of the enforceability of the Restriction is governed by federal law rather than Oregon LLC law. Under applicable Ninth Circuit precedent, "[i]t is against public policy for a debtor to waive the prepetition protection of the Bankruptcy Code... otherwise, astute creditors would require their debtors to waive" the ability to file for bankruptcy (Bank of China v. Huang (In re Huang), 275 F.3d 1173, 1177 (9th Cir. 2002)).

The Court viewed the Lender's request to include the Restriction in the Debtor's operating agreement as more "insidious" than had it requested to include it in the loan documents, where it would normally appear. The Court explained that including the Restriction in the Operating Agreement, which was signed only by the Debtor's members, rather than in the loan documents, which were signed by both the Lender and the Debtor, was a "distinction without a meaningful difference." Further, the Court described this as just a maneuver of an "astute creditor" to preclude the Debtor from availing itself of the Bankruptcy Code's protections prepetition, which is unenforceable as a matter of public policy.

Additionally, the broad powers granted to the Manager in the operating agreement gave it the authority to file a Chapter 11 case. Therefore, unanimous LLC member consent to file for bankruptcy protection was not necessary. As a result, the Court allowed the Chapter 11 filing to proceed and denied the Lender's motion to dismiss the Debtor's bankruptcy case.

This decision demonstrates the difficulty in "bankruptcy proofing" a borrower. In this case, by refusing to make a legal distinction between a bankruptcy restriction contained in an LLC operating agreement among only the LLC members and a bankruptcy waiver contained in a loan agreement between the Lender and the LLC, the Court would not allow the Lender to do indirectly what it could not do directly. The Court recognized that both ultimately operate to deprive an entity from the prepetition protection of the Bankruptcy Code, which is against public policy.

While courts view express restrictions on filing for bankruptcy protection unfavorably, they may uphold certain less restrictive means of reducing the probability of a borrower's bankruptcy filing. For instance, if the operating agreement had explicitly required the unanimous consent of the LLC members to file for bankruptcy, the Court likely would have upheld this provision and dismissed the case.

For more information on LLCs and the Bankruptcy Code, see Practice Note, Limited Liability Companies and the Bankruptcy Code.