FIELDING.FMT.DOC 3/3/2005 12:04 PM PREVENTING VOLUNTARY AND INVOLUNTARY BANKRUPTCY PETITIONS BY LIMITED LIABILITY COMPANIES by Michael D. Fielding* INTRODUCTION The limited liability company (LLC) has recently become a very “popular form of business organization”1 because it allows members to participate in the company’s management without the exposure 2 of personal liability. In other words, LLC members are not personally liable for the debts, obligations, or liabilities of the LLC simply because of their membership.3 Additionally, the IRS recently promulgated regulations that allow LLCs to be taxed as partnerships without meeting the four-part test formerly used to determine whether the company should be taxed as a partnership or 4 corporation. Thus, the corporate-like liability protection coupled with the partnership-type taxation makes an LLC a highly preferable business entity—particularly for small companies. Creditors often require LLCs (and other business entities) to sign contractual provisions that make it difficult or practically impossible for the debtor to declare bankruptcy. The purpose of these provisions is to allow creditors to repossess all or a portion of their collateral before bankruptcy is filed. While no one can legally prohibit an LLC or other business entity from filing for bankruptcy,5 * Associate, Blackwell Sanders Peper Martin, L.L.P., Kansas City, Missouri (Commercial Litigation Creditor’s Rights Department); J.D., Brigham Young University, 2001; B.A. Economics, Brigham Young University, 1998. 1 Broyhill v. DeLuca (In re DeLuca), 194 B.R. 65, 71 (Bankr. E.D. Va. 1996). 2 Harold S. Novikoff & Barbara S. Kohl, Bankruptcy “Proofing”: Bankruptcy Remote Vehicles and Bankruptcy Waivers, SE71 A.L.I.–A.B.A.1, 7 (Feb. 24, 2000). 3 See, e.g., KAN. STAT. ANN. § 17-7688 (2000); MO. ANN. STAT. § 347.057 (West 2001); UTAH CODE ANN. § 48-2c-601 (2001). 4 Novikoff & Kohl, supra note 2, at 7. 5 See id. at 11; see also infra Part II. 51 FIELDING.FMT.DOC 3/3/2005 12:04 PM 52 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 there are a number of “hindrance mechanisms” that can be employed to deter significantly a bankruptcy petition. A “hindrance mechanism” is any sort of contractual device between the debtor and creditor that creates a disincentive for the debtor to file voluntarily for bankruptcy. As this Article illustrates, a number of hindrance mechanisms are of questionable legality, regardless of the business entity to which they are applied. However, in the case of an LLC there is additional ambiguity because the relatively recent advent of the LLC as a favorable form of business organization means there is little bankruptcy law dealing specifically with LLC issues.6 Thus, the application of hindrance mechanisms to LLCs raises numerous questions for practitioners. As the title suggests, this Article examines various hindrance mechanisms that may be employed to hinder significantly or practically stop an unwanted bankruptcy filing by an LLC. Part I discusses overarching issues that should be considered before implementing any hindrance mechanism. Part II then examines specific hindrance mechanisms that may be employed to deter an LLC from filing a bankruptcy petition. Potential problems for both creditors and debtors who employ these devices are also evaluated. Finally, Part III considers bankruptcy posturing that both creditors and debtors may make if an LLC ultimately files for bankruptcy— either voluntarily or involuntarily. I. OVERARCHING STATUTES AND CASE LAW THAT MUST BE STRONGLY CONSIDERED BEFORE CREATING ANY BANKRUPTCY HINDRANCE MECHANISM Before creating, accepting, or implementing any sort of bankruptcy hindrance mechanism, creditors and debtors should carefully consider the roles of anti-ipso facto clauses, state LLC laws, and the debtor’s fiduciary duties. If not properly accounted for, these overarching statutes and legal principles could render a hindrance mechanism per se invalid without any consideration for the actual contractual device. 6 Novikoff & Kohl, supra note 2, at 7. Indeed, there are no Code provisions that deal directly with the LLC and only a few cases that address LLC specific issues in bankruptcy. See, e.g., In re Garrison-Ashburn, L.C., 253 B.R. 700 (E.D. Va. 2000); JTB Enters. v. D&B Venture, L.C. (In re DeLuca), 194 B.R. 79 (Bankr. E.D. Va. 1996); In re DeLuca, 194 B.R. 65; In re Daugherty Constr., Inc., 188 B.R. 607 (Bankr. D. Neb. 1995). FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 53 A. Anti-ipso Facto Clause Provisions As a rule of law, the Bankruptcy Code prohibits the operation 7 of ipso facto clauses. As such, any hindrance mechanism that creates an ipso facto clause will be per se invalid. An ipso facto clause is a “contract clause or state law designed to effect a forfeiture or modification of the Debtor’s rights when a bankruptcy is filed.”8 Certain provisions of the Code “render ineffective contractual or statutory provisions which purport to modify or terminate rights of the debtor based on bankruptcy or financial condition.”9 The Bankruptcy Code makes ipso facto clauses unenforceable in five different places: § 363(l)10 (trustee may use, sell, or lease property despite any provision in a contract, a lease, or applicable law that is conditioned on the bankruptcy or insolvency of a debtor); § 365(e)(1)11 (executory contracts may not be 7 Hayhoe v. Cole (In re Cole), 226 B.R. 647, 652 (9th Cir. B.A.P. 1998). 8 Joyce A. Dixon & T. Randall Wright, Bankruptcy Issues in Partnership and Limited Liability Company Cases, SD83 A.L.I. – A.B.A. 189, 194 (May 13, 1999). 9 Sally S. Neely, Partnerships and Partners and Limited Liability Companies and Members in Bankruptcy: Proposals for Reform, 71 AM. BANKR. L. J., 271, 296-97 (1997). 10 11 U.S.C. § 363(l) (2000) provides: (l) Subject to the provisions of section 365, the trustee may use, sell, or lease property under subsection (b) or (c) of this section, or a plan under chapter 11, 12, or 13 of this title may provide for the use, sale, or lease of property, notwithstanding any provision in a contract, a lease, or applicable law that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title concerning the debtor, or on the appointment of or the taking possession by a trustee in a case under this title or a custodian, and that effects, or gives an option to effect, a forfeiture, modification, or termination of the debtor’s interest in such property. 11 11 U.S.C. § 365(e) provides: (e) (1) Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on— (A) the insolvency or financial condition of the debtor at any time before the closing of the case; (B) the commencement of a case under this title; or (C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement. (2) Paragraph (1) of this subsection does not apply to an executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if— (A)(i) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to the FIELDING.FMT.DOC 3/3/2005 12:04 PM 54 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 terminated or modified because of a contract provision or the 12 operation of applicable law); § 365(f)(1) (trustee may assign a contract or lease despite contrary contractual or legal provisions); § 365(f)(3)13 (contracts cannot be modified because a trustee 14 assumes them); and § 541(c)(1)(B) (an interest of the debtor becomes property of the estate upon the filing of a bankruptcy despite contrary contractual provisions).15 Despite these five separate provisions, the practical prohibition of these clauses is somewhat limited: three of the anti-ipso facto clause provisions deal with restrictions based upon the appointment of a trustee, while the other two deal with executory contracts and the debtor’s estate. trustee or to an assignee of such contract or lease, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and (ii) such party does not consent to such assumption or assignment; or (B) such contract is a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor. 12 11 U.S.C. § 365(f)(1) provides: (f)(1) Except as provided in subsection (c) of this section, notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease under paragraph (2) of this subsection; except that the trustee may not assign an unexpired lease of nonresidential real property under which the debtor is an affected air carrier that is the lessee of an aircraft terminal or aircraft gate if there has occurred a termination event. 13 11 U.S.C. § 365(f)(3) provides: (f)(3) Notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law that terminates or modifies, or permits a party other than the debtor to terminate or modify, such contract or lease or a right or obligation under such contract or lease on account of an assignment of such contract or lease, such contract, lease, right, or obligation may not be terminated or modified under such provision because of the assumption or assignment of such contract or lease by the trustee. 14 11 U.S.C. § 541(c)(1)(B) provides: (c)(1) Except as provided in paragraph (2) of this subsection, an interest of the debtor in property becomes property of the estate under subsection (a)(1), (a)(2), or (a)(5) of this section notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law— (A) that restricts or conditions transfer of such interest by the debtor; or (B) that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property. 15 See Dixon & Wright, supra note 8, at 194-95; Neely, supra note 9, at 295-96. FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 55 Although the anti-ipso facto provisions cannot be circumvented, the scope of their impact can be avoided through a carefully crafted hindrance mechanism. B. State Laws State statutes governing LLCs typically provide unique opportunities for implementing bankruptcy hindrance mechanisms. From a creditor’s standpoint, one of the greatest benefits of dealing with an LLC is that its entire governing structure can be easily changed and manipulated. This is particularly true because LLCs are not required to observe certain legal formalities required of corporations.16 The malleability of the LLC stems from flexible state laws that allow members to create business entities that may be run as corporations, partnerships, or some hybrid of these two polar extremes.17 This tremendous flexibility gives an imaginative creditor virtually unlimited opportunity to implement creative controls on LLCs. Furthermore, state laws allow LLC members to grant a creditor greater influence over the company while the members retain the power to operate the company below the creditor’s overarching rules. Simply stated, LLCs give both creditors and members greater flexibility in determining how the company will be run and what liabilities the company will accept in return for much needed capital.18 A unique feature of the limited liability company is that some state statutes allow members to determine the level of their fiduciary duties.19 In contrast, other states do not expressly grant such wide 16 See, e.g., KAN. STAT. ANN. §§ 17-7627 to -76,142 (2000); MO. ANN. STAT. §§ 347.010-.189 (West 2001); UTAH CODE ANN. § 48-2c-101 to -1902 (2001). 17 Examples of various state laws governing the creation and self-government of LLCs include KAN. STAT. ANN. § 17-7627 to -76,142 (2000); MO. ANN. STAT. §§ 347.010–.189 (West 2001); UTAH CODE ANN. § 48-2c-101 to -1902 (2001). 18 Given both the tremendous benefits and flexibility of an LLC, one would expect to see future creditors strongly encouraging or even requiring companies to convert to an LLC before loan proceeds are disbursed. Imposing the LLC conversion requirement would give the creditor opportunities to obtain better leverage and protection than it might otherwise get from a corporation or limited partnership. 19 See, e.g., KAN. STAT. ANN. § 17-76,134. Section 17-76,134 specifically states: (a) The rule that statutes in derogation of the common law are to be strictly construed shall have no application to this act. (b) It is the policy of this act to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements. (c) To the extent that, at law or in equity, a member or manager or other person FIELDING.FMT.DOC 3/3/2005 12:04 PM 56 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 flexibility to LLC members.20 However, even in these more “limited” states, LLC members still have wide latitude in determining the level 21 of their fiduciary obligations. Finally, some states appear to grant relativlely less flexibility toward adjusting a member’s fiduciary 22 obligations. The wide range in state treatment of fiduciary duties is an extremely important consideration when determining which laws to organize an LLC under and what controls a creditor may desire to impose on a company.23 The flexibility of fiduciary duties is has duties (including fiduciary duties) and liabilities relating thereto to a limited liability company or to another member or manager: (1) Any such member or manager or other person acting under an operating agreement shall not be liable to the limited liability company or to any such other member or manager for the member’s or manager’s or other person’s good faith reliance on the provisions of the operating agreement; and (2) The member’s or manager’s or other person’s duties and liabilities may be expanded or restricted by provisions in an operating agreement. The Kansas Limited Liability Company Act was patterned after the Delaware Limited Liability Company Act. Edwin W. Hecker, Jr., The Kansas Revised Limited Liability Company Act, 69 J. KAN. BAR ASS’N 16, 16 (2000). 20 See, e.g., UTAH CODE ANN. §§ 48-2c-101 to –1902 (2001); MO. ANN. STAT. §§ 347.010 – .189 (West 2001). In Utah, for example, it appears that LLC members would have a difficult time escaping from certain fiduciary obligations. The Utah Code defines a “fiduciary” in relevant part as a “assignee for the benefit of creditors, partner, agent, officer of a corporation, public or private. . .and any other person acting in a fiduciary capacity for any person.” UTAH CODE ANN. § 22-1-1 (1998). 21 See, e.g., MO. ANN. STAT. §§ 347.081, 347.088. It should be noted that the flexibility given to Missouri LLCs is more akin to that of Kansas than Utah. 22 See, e.g., UTAH CODE ANN. §§ 48-2(c)-403, -502, –602-03. A review of these statutes indicates that there is no statutory leeway to alter fiduciary duties owed to creditors. In contrast, members may be able to restructure in the operating agreement the fiduciary duties that are owed to one another. 23 While the Kansas LLC statutes allow significant fiduciary flexibility, at least one commentator believes that the fiduciary obligations of LLC members to each other will continue to remain. Hecker, supra note 19, at 32-34. Hecker notes: The essence of a fiduciary relationship is a situation in which a person transacts business or handles money or other property, not primarily for his or her own benefit, but for the benefit of another. It is a relationship that involves discretionary authority on the part of the fiduciary and dependency and reliance on the part of the beneficiary. Id. at 32. He then analyzes fiduciary duties in partnerships, limited partnerships, and corporations. Id. at 33. He applies this analogous law to LLCs: If the LLC is member-managed, all members would be agents of the LLC and would occupy a fiduciary relationship to the LLC and to each other similar to that of partners in a general partnership. If exclusive management power is vested in managers, the managers (whether or not they also are members) would be subject to fiduciary duties akin to those of corporate officers and directors or general partners of limited partnerships. The nonmanaging members, whose position is analogous to that of shareholders or limited partners, generally would not be FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 57 important because these duties can be structured to create positive or negative incentives that will influence how a particular member acts in a given situation. Before implementing any bankruptcy hindrance mechanism, a creditor should also carefully consider the fiduciary role that a debtor LLC will owe to a third-party creditor. It is almost universally agreed that corporate directors owe a fiduciary duty to the corporation’s general creditors when the company becomes insolvent.24 While there is scant case law dealing directly with LLCs,25 it is reasonable to infer that courts would hold that LLC members also have a fiduciary duty to the company’s general creditors once it becomes insolvent. Thus, any bankruptcy hindrance mechanism must consider potential ramifications for both the creditor and the debtor if the mechanism strongly encourages the debtor to breach a fiduciary duty owed to a third- party creditor. Finally, in considering which state law to organize an LLC under, practitioners must carefully consider the recent tax changes and how state statutes have (or have not) been modified to reflect these new laws. Prior to 1997, the IRS followed the Kinter Regulations to determine whether a business entity would be taxed as a partnership or corporation.26 Under this scheme, a limited liability company would be taxed as a partnership if it had, at most, two of the four corporate characteristics (i.e., continuous life, centralized management, limited liability, and interests that could 27 be freely transferred). As a result of these regulations, many (if not subject to fiduciary obligations. If the LLC has adopted a hybrid structure, under which it has managers but certain managerial decisions are reserved to the members at large, each group would be subject to fiduciary responsibility within the sphere of its managerial authority. This is the general approach taken by the drafters of the Uniform Limited Liability Company Act and which may, over time, recommend itself to the Kansas courts. Id. at 33 (citation omitted). 24 See In re Kingston Square Assocs., 214 B.R. 713, 735 (Bankr. S.D.N.Y. 1997). 25 The following are some of the few reported cases dealing directly with LLC issues in bankruptcy. See generally In re Garrison-Ashburn, L.C., 253 B.R. 700 (Bankr. E.D. Va. 2000); JTB Enters. L.C. v. D&B Venture, L.C. (In re DeLuca), 194 B.R. 79 (Bankr. E.D. Va. 1996); Broyhill v. DeLuca (In re DeLuca), 194 B.R. 65 (Bankr. E.D. Va. 1996); In re Daugherty Constr., Inc., 188 B.R. 607 (Bankr. D. Neb. 1995). 26 See Neely, supra note 9, at 280. 27 Id. FIELDING.FMT.DOC 3/3/2005 12:04 PM 58 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 all) state LLC laws were structured so that an LLC would be entitled 28 to the preferential tax treatment. In 1997, however, the IRS adopted new regulations that enabled business entities (including LLCs) to be taxed as a partnership without regard to the four “corporate” characteristics.29 Yet despite these “advances” in tax regulation, not all state legislatures have modified their existing LLC laws.30 The net result is that although federal tax laws are now more favorable toward LLCs, some state provisions are structured as if the old tax regulations were still in effect. Thus, when considering any sort of hindrance mechanism, a practitioner should look at state LLC laws in multiple states to find which law provides greater flexibility. C. Kingston Square The In re Kingston Square Associates31 decision raises a warning flag, not only to anyone considering the use of a bankruptcy remote 32 vehicle in an LLC, but also to those employing any bankruptcy hindrance mechanism that implicates fiduciary duties. At issue in Kingston Square was whether the bankruptcy petitions of eleven separate debtors33 should have been dismissed as bad faith filings.34 The lenders35 had previously loaned approximately $277 million to thirty-eight separate entities that were all wholly or partially 36 controlled by one individual—Morton Ginsberg. At the time of the Kingston Square decision all thirty-eight entities were in 28 See, e.g., In re Garrison-Ashburn, 253 B.R. at 706 (noting that prior to 1997 state laws were often structured such that an LLC only had one corporate characteristic—centralized management). 29 Neely, supra note 9, at 280. The current tax regulations defining the classification of a business entity for tax purposes are located at 26 C.F.R. §§ 301.7701-1 to -4 (2001). 30 Compare In re Garrison-Ashburn, 253 B.R. at 706 (noting that Virginia LLC law was changed to reflect current tax regulations) with Missouri Revised Statutes §§ 347.010–.185, which still contain provisions reflecting the Kinter regulations (e.g., MO. ANN. STAT. §§ 347.115 and 347.185 (West 2001)). 31 See generally In re Kingston Square Assocs., 214 B.R. 713 (Bankr. S.D.N.Y. 1997). 32 “Bankruptcy remote vehicles” (a method to prevent or hinder a bankruptcy by adding provisions to a company’s articles of incorporation that make filing bankruptcy almost impossible) are discussed in greater detail in Part II.B, infra. 33 Each debtor was wholly or partially controlled by the same individual. 214 B.R. at 715. 34 Id. 35 The lenders were Chase Manhattan Bank, N.A., and REFG Investor Two, Inc. Id. 36 Id. at 715-16. FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 59 receivership with pending foreclosure proceedings.37 The eleven entities that had filed for bankruptcy each owned a single parcel of 38 multi-family real property in either New York or Florida. The lenders loaned money to all thirty-eight entities on condition that each debtor (whether a corporation or partnership) amend its bylaws to include a “bankruptcy remote” or “bankruptcy proof” provision.39 The amendment required that unanimous consent be given by either the corporate board or by the corporate general partner (for partnerships) before the company could file for bankruptcy.40 To ensure that a bankruptcy was never filed, the lenders required that an “independent director” be appointed as a corporate director for the corporation or for the corporate general partner.41 Aside from receiving $25,000 per year from the lenders 42 for his role in the corporations, the independent director apparently did not perform any other corporate duties or responsibilities.43 In 1994, the lenders issued notices of default and commenced 44 legal proceedings against each property. By 1996, the lenders obtained approximately $370 million in judgments and they 45 commenced foreclosure against all thirty-eight properties. Despite the legal proceedings, the directors of each entity took no action to oppose the foreclosure because they believed that the “independent director” would thwart their attempts.46 It was estimated that the properties contained equity that would be lost at foreclosure; thus the unsecured creditors and limited partners would not receive anything unless bankruptcy was filed for each entity.47 At the beckoning of Ginsberg, six creditors48 finally filed an involuntary petition against the eleven debtors.49 The lenders 37 Id. at 715. 38 Id. at 715-16. 39 Id. at 716. 40 Id. 41 Id. at 716-17. 42 Id. at 717. 43 Id. at 721. 44 Id. at 717. 45 Id. 46 Id. at 720-21. 47 Id. at 719. 48 The six creditors included one trade creditor. Id. at 726. The other five “came from the battery of professionals that the Debtors employed to fight the [lenders] in the numerous state court actions.” Id.; see also id. at 718. FIELDING.FMT.DOC 3/3/2005 12:04 PM 60 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 subsequently moved to dismiss the claims as constituting bad faith 50 filings because the petitions had been induced by Ginsberg. The bankruptcy court concluded that although the debtors orchestrated the filing, they believed bankruptcy was a viable alternative and they had not violated any laws or court orders in seeking the involuntary petitions.51 However, the court appointed chapter 11 trustees for each bankrupt entity because the evidence suggested that the 52 directors had abdicated their fiduciary responsibilities. In its analysis, the bankruptcy court was particularly critical of the independent director. It noted that the independent director had not taken an interest in any of the properties.53 Despite this complete neglect of his corporate responsibilities, the independent director often inquired about his late fees owed to him by a lender.54 When the bankruptcy court strongly suggested that the corporate 55 directors hold a board meeting, the independent director engaged in various stall tactics to prevent ratification of the bankruptcy 56 filings. Once the independent director learned that the lender (under whose direction he operated) had foreclosed on all of the proceedings, he inquired of the lender to determine if he should resign.57 In short, the court concluded that the independent director largely (if not wholly) ignored his fiduciary duties and corporate loyalties that stemmed from his corporate role.58 The court also approved Ginsberg’s actions in seeking 59 bankruptcy given the impediments of the independent director. The court cited with approval Management Technologies, Inc. v. 60 61 Morris and In re Spanish Cay Co. for the proposition that “corporate action taken by an insider without board or shareholder authority may later be found to have been appropriate in 49 Id. at 726. 50 Id. at 714. 51 Id. at 714-15, 738-39. 52 Id. at 715, 738-39. 53 Id. at 721. 54 Id. 55 Id. at 722. 56 Id. 57 Id. at 722-23. 58 Id. at 730. 59 Id. at 731. 60 See Mgmt. Techs., Inc. v. Morris, 961 F. Supp. 640, 647-49 (S.D.N.Y. 1997). 61 See In re Spanish Cay Co., 161 B.R. 715, 722-23 (Bankr. S.D. Fla. 1993). FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 61 circumstances where the existence of the corporation is very much 62 at risk.” In other words, the court approved the actions of Ginsberg, an insider, to seek a bankruptcy where his actions apparently saved the debtors from financial ruin.63 The lessons of Kingston Square should be considered carefully by both creditors and debtors. Creditors must carefully determine whether their bankruptcy hindrance mechanisms directly or indirectly force LLC members to breach either contractual or legally imposed fiduciary duties. On the other hand, debtors caught between “a rock and a hard place” because of a hindrance mechanism have precedent on which to seek an involuntary bankruptcy filing.64 However, a carefully crafted bankruptcy hindrance mechanism could make even this remedy difficult to obtain. II. HINDRANCE MECHANISMS: 65 BANKRUPTCY PROOFING STRATEGIES Although it is almost universally agreed that an entity cannot absolutely waive the right to file a voluntary bankruptcy petition,66 67 numerous pre-petition waivers (or hindrance mechanisms) have been devised to make a voluntary filing difficult.68 While this 62 In re Kingston Square, 214 B.R. at 731. 63 See id. 64 See Part III, infra, for a discussion regarding voluntary and involuntary bankruptcy filings, particularly involuntary filings by corporations and LLCs. 65 Although not directly covered in this Article, there are a number of “bankruptcy- proofing” strategies that can be implemented in a franchisor-franchisee context. See generally Dean T. Fournaris & Craig R. Tractenberg, “Bankruptcy-Proofing” Franchise Contracts to Reduce Debtor-Related Risks, 6 LEADER’S FRANCHISING BUSINESS & LAW ALERT 1 (Mar. 2000). 66 See Novikoff & Kohl, supra note 2, at 11. 67 As used in this Article, a “pre-petition waiver” constitutes a contract entered into by the debtor and a creditor where the debtor voluntarily waives a right guaranteed in bankruptcy in exchange for consideration by the creditor. 68 See, e.g., Hayhoe v. Cole (In re Cole), 226 B.R. 647, 651 n.6 (9th Cir. B.A.P. 1998) (noting that numerous trial courts have held pre-petition waivers of the bankruptcy discharge unenforceable) (citing Giaimo v. Detrano (In re Detrano), 222 B.R. 685, 688 (Bankr. E.D.N.Y. 1998); Minor v. Chilcoat (In re Minor), 115 B.R. 690, 694-96 (D. Colo. 1990); Doug Howle’s Paces Ferry Dodge, Inc. v. Ethridge (In re Ethridge), 80 B.R. 581, 586 (Bankr. M.D. Ga. 1987); First Ga. Bank v. Halpern (In re Halpern), 50 B.R. 260, 262 (Bankr. N.D. Ga. 1985), aff’d, 810 F.2d 1061 (11th Cir. 1987); Bisbach v. Bisbach (In re Bisbach), 36 B.R. 350, 352 (Bankr. W.D. Wis. 1984); Johnson v. Kriger (In re Kriger), 2 B.R. 19, 23 (Bankr. D. Or. 1979)). FIELDING.FMT.DOC 3/3/2005 12:04 PM 62 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 strategy does not completely eliminate the risk of bankruptcy, it reduces the probability of an unwanted filing. Before proceeding with an analysis of hindrance mechanisms, it should be noted that several courts have held as void various pre- 69 petition waivers of certain bankruptcy rights. The rationale for prohibiting contractual waivers of bankruptcy provisions was succinctly summed up in the recent In re 203 North LaSalle Street Partnership decision; “[s]ince bankruptcy is designed to produce a system of reorganization and distribution different from what would obtain under nonbankruptcy law, it would defeat the purpose of the Code to allow parties to provide by contract that the provisions of the Code should not apply.”70 Given this rationale, one would assume that most or all hindrance mechanisms (or pre-petition agreements) would be void as against public policy because they attempt to give a creditor a better position than he would otherwise 69 Two recent cases cite several examples where courts questioned the validity of pre- petition waivers. See In re Cole, 226 B.R. at 651 n.7 (citing In re Shady Grove Tech Ctr. Assocs , 216 B.R. 386, 390 (Bankr. D. Md. 1998) (holding that automatic stay waivers are unenforceable); In re Madison, 184 B.R. 686, 690 (Bankr. E.D. Pa. 1995) (pre-petition contract where debtor agreed not to file bankruptcy for 180 days was void as against public policy); In re Gulf Beach Dev. Corp., 48 B.R. 40, 43 (Bankr. M.D. Fla. 1985) (“the Debtor cannot be precluded from exercising its right to file Bankruptcy and any contractual provision to the contrary is unenforceable as a matter of law”); In re Tru Block Concrete Prods., Inc., 27 B.R. 486, 492 (Bankr. S.D. Cal. 1983) (an agreement that had the same intention of a chapter 11 proceeding but contained a provision prohibiting the filing of bankruptcy was deemed void as against public policy)) and Minn. Corn Processors, Inc. v. American Sweeteners, Inc. (In re American Sweeteners, Inc.), 248 B.R. 271, 278 n. 6 (Bankr. E.D. Pa. 2000) (citing In re Fallick, 369 F.2d 899, 904 (2d Cir. 1966) (“[T]he bankruptcy [code] expresses a strong legislative desire that deserving debtors be allowed to get a fresh start . . . . [A]n advance agreement to waive the benefits of the [Code] would be void.”); Bank of America v. N. LaSalle St. L.P. (In re 203 N. LaSalle St. P’ship), 246 B.R. 325, 331 (Bankr. N.D. Ill. 2000) (“It is generally understood that pre-bankruptcy agreements do not override contrary provisions of the Bankruptcy Code.” The court held that a pre-petition subordination agreement would not be enforced. “[I]t would defeat the purpose of the [Bankruptcy] Code to allow parties to provide by contract that the provisions of the Code should not apply.”); In re Heward Bros., 210 B.R. 475, 479 (Bankr. D. Idaho 1997) (“[A] prepetition agreement to waive a benefit of bankruptcy is void as against public policy.”); In re Pease, 195 B.R. 431, 435 (Bankr. D. Neb. 1996) (Pre-petition waivers of the automatic stay are per se unenforceable. “[A]ny attempt by a creditor in a private pre-bankruptcy agreement to opt out of the collective consequences of a debtor’s future bankruptcy filing is generally unenforceable.” The court then noted that the Bankruptcy Code offers many remedies to protect a creditor’s interest such that there was “no need or justification” for enforcing a pre-petition agreement.)). It is important to note that although the cases above are cited for the proposition that a company cannot waive the right to file for bankruptcy, many of the cases upheld waivers of certain bankruptcy petitions. 70 In re 203 N. LaSalle St. P’ship, 246 B.R. at 331. FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 63 have.71 Indeed, the Bankruptcy Code provides various remedies that 72 are designed to protect a creditor’s interest sufficiently. Despite these reasons, some courts have continued to allow certain pre- petition waivers.73 Until the Bankruptcy Code is revised or a definitive Supreme Court decision is handed down, one can expect to find courts affirming the use of pre-petition agreements. Indeed, creditors who fail to employ such devices may be compromising their future position to a more aggressive creditor who has implemented contractual devices that create an implicit special preference in bankruptcy. Thus, all creditors must know and 71 A bankruptcy filing is analogous to a lifeboat in the ocean. The secured creditors are the people who sit in the boat, while the unsecured creditors are those in the water desperately clinging to the vessel. The boat itself represents the company that is barely staying above water. The goal of the bankruptcy filing is to preserve the interest of as many creditors as possible. Oftentimes, this requires keeping the boat together so that all may have something to cling to (i.e., the whole is greater than the sum of the parts). In other more rare occasions, the boat must be torn apart leaving each creditor to fend for himself according to what he has his hands on. Regardless of whether the boat is kept together or torn apart, the goal of bankruptcy is the same: treat each of the creditors the same with preferences toward the secured creditors. Despite this attempted equality, certain creditors (like survivors clinging for life) will attempt to preserve their own self-interest at the expense of the other creditors. Indeed, this “every man for himself” attitude necessarily requires that each creditor engage in shrewd tactics to gain an advantage over the other creditors. The increased competition for boat space creates at least two problems. First, the boat itself is subjected to unnecessary pulling and tugging as creditors vie and posture to get a better position. The rampant self-interest puts the boat under greater strain (which may ultimately be too much to handle). Ultimately one creditor may obtain a significant portion of the boat at the expense of other creditors (and even at the expense of the boat itself). Instead of barely saving each of the creditors, the net result is that one creditor is saved in comfort while many others have lost any benefit that the boat may have once offered to them. Second, even if the boat survives the tugging and pulling of the creditors, the majority of the creditors will likely be worse off than when they started because significant time and energy has been expended simply fighting to stay alive. If there were rules that prohibited attempts to grab more of the boat, then less energy would be expended and the boat could focus on how to better stay afloat. 72 See, e.g., In re Pease, 195 B.R. at 435 (citing protections of the Bankruptcy Code that void the necessity of a pre-petition waiver of the automatic stay). 73 See, e.g., In re Wald, 211 B.R. 359, 361 (Bankr. D. N.D. 1997) (involving a stipulation entered into during a previous bankruptcy proceeding where the debtor agreed to allow the creditor to proceed with foreclosure proceedings upon the debtor’s default. The bankruptcy court held these stipulations were common and a showing of special circumstances would be required to relieve the debtor from the stipulation). See also In re Gulf Beach Dev., 48 B.R. at 43 (lifting the automatic stay to allow the bank to proceed with a foreclosure proceeding where the debtor had previously executed a settlement agreement in which it was released from its debt, but where the debtor agreed to an entry of final judgment in the foreclosure proceedings. The debtor filed for bankruptcy hoping to avoid the foreclosure proceedings while reaping the benefits of the release from debt.). FIELDING.FMT.DOC 3/3/2005 12:04 PM 64 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 understand not only what bankruptcy hindrance mechanisms exist, but also how implementing those devices may affect them either directly or indirectly. What follows below is a brief analysis of some of the various devices that have been used or suggested in the last few years. A. Personal Guaranty One method to deter an unwanted bankruptcy is to obtain a personal guaranty that is contingent upon a bankruptcy filing.74 There are two types of personal guaranties that can be obtained.75 The first is a “springing guaranty” that is given by an insider (i.e., a member or managing director) and becomes effective (i.e., the insider becomes personally liable) upon the occurrence of certain conditions, typically a bankruptcy filing by the company or failure to dismiss quickly an involuntary bankruptcy petition.76 The second personal guaranty is an “exploding guaranty,” where the insider will become personally liable for the company’s debt if it contests the lender’s rights in the bankruptcy proceeding.77 In other words, an exploding guaranty requires the insider to not contest actions taken by the lender against the company in the company’s bankruptcy proceedings.78 Currently, there is very little case law regarding the legitimacy 79 of springing and exploding guaranties. However, at least one commentator has suggested that personal guaranties cause the insider to violate his fiduciary duties to other creditors of the company because there is an inherent conflict between the insider’s 74 See Marshall E. Tracht, Will Exploding Guaranties Bomb?, 117 BANKING L. J. 129, 129. (2000) (hereinafter Tracht, Exploding Guaranties). For more information on guaranties in bankruptcy, see also, Marshall E. Tracht, Insider Guaranties in Bankruptcy: A Framework for Analysis, 54 U. MIAMI L. REV. 497 (April 2000). 75 Tracht, Exploding Guaranties, supra note 74 at 129. 76 Id. 77 Id. 78 See id. 79 According to Marshall E. Tracht, only two cases have dealt with bankruptcy contingent guaranties. See id. at 130-31 (citing FDIC v. Prince George Corp., 58 F.3d 1041 (4th Cir. 1995) and First Nationwide Bank v. Brookhaven Realty Assocs., 637 N.Y.S.2d 418 (1996)). Tracht states that both these cases enforced contingency provisions involving a bankruptcy carve-out in a nonrecourse mortgage. Id. He opines that neither decision provides much guidance because the bankruptcy proceedings had been terminated prior to the suit involving the personal guaranty and each debtor had very few (if any) creditors. See id. at 130-31. FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 65 self-interest and the best interest of the company’s creditors.80 It has also been suggested that personal guaranties violate bankruptcy policy because they do not maximize a company’s overall value for the benefit of all creditors.81 Indeed, the analysis in Kingston Square strongly suggests that personal guaranties that favor a violation of 82 fiduciary duties will be disfavored by the law. Thus, even though certain fiduciary duties in LLCs are malleable under state law,83 the 84 duties owed to third-party creditors may not be waivable. In other words, the inherent conflict between the insider’s self-interest and the best interest of the company’s creditors might be impossible to overcome contractually.85 Despite the problems with personal 80 See Tracht, Exploding Guaranties, supra note 74, at 132. Tracht’s argument regarding the fiduciary duties assumes that it would not be in the best interest of the company’s other creditors to permit the creditor with the exploding or springing guaranty to pursue his remedies against the company. While this assumption is generally true, the careful creditor seeking a personal guaranty could attempt to structure the guaranty in such a way to harmonize the self-interest of the insider with those of the other creditors. 81 See id. at 134. Tracht gives a simple hypothetical to show why personal guaranties violate bankruptcy policy. Consider a hypothetical firm, with a liquidation value of $70 and a reorganization value of $80. The firm has $100 in unsecured debt, $50 of which has been protected with a springing guaranty and $50 of which is not guarantied. Clearly the firm should be reorganized, in which case creditors will lose only $20 rather than $30. From the insider’s perspective, however, the choice is between nonbankruptcy liquidation with no personal liability, and bankruptcy reorganization with a personal liability of $10. In other words, the incentives created by a bankruptcy- contingent guaranty may prevent efficient bankruptcy filings. Id. Tracht’s hypothetical illustrates that the ultimate objective of a bankruptcy proceeding is to maximize the company’s overall value. In contrast, a personal guaranty generally creates an incentive for the insider to maximize his own self-interest at the expense of other creditors. Arguably, a personal guaranty would not violate the bankruptcy policy if its net effect were to maximize the company’s overall value. In other words, a major creditor of the company could structure the guaranty in such a way that it would assume control (at least temporarily) of the company should revenues or operations drop below a minimum threshold. While this step may be adversely viewed by minor creditors (i.e., those with relatively small claims against the company), the overall net effect might actually enhance the company’s going-concern because new management has been put in place without a burdensome bankruptcy proceeding. 82 See generally In re Kingston Square Assocs., 214 B.R. 713 (Bankr. S.D.N.Y. 1997); see also supra Part I.C. 83 See supra Part I.B. 84 See, e.g., In re Kingston Square, 214 B.R. at 735. 85 See Tracht, Exploding Guarantees, supra note 74, at 129, 132. Tracht’s argument regarding the fiduciary duties assumes that it would not be in the best interest of the company’s other creditors to let the creditor with the exploding or springing guaranty to pursue his remedies against the company. While this assumption is generally true, the careful FIELDING.FMT.DOC 3/3/2005 12:04 PM 66 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 guaranties, these devices will continue to be a valuable deterrent to 86 unwanted bankruptcies until more case law is developed. B. Provisions in Organizational Documents (Remote Vehicles) A second (and relatively simple) method to hinder or prevent an unwanted bankruptcy is to create a “bankruptcy remote vehicle”87 by adding provisions to a company’s articles of organization that make a voluntary bankruptcy filing difficult or practically impossible.88 Such provisions require a unanimous or supermajority consent of all directors or shareholders before the company may file 89 for bankruptcy. This strategy can be easily implemented for LLCs, corporations, or voluntary partnership filings.90 The catch to the supermajority or unanimous vote requirement is that a secured creditor will often want to designate an “independent” voter who will ensure that the supermajority or unanimous approval for a bankruptcy will not be obtained.91 The secured creditor’s intention is to create a situation where (1) assets will be peacefully surrendered or (2) there will be no bankruptcy proceedings to hinder a state law foreclosure.92 The obvious downside to this approach is that the creditor’s influence may cause creditor seeking a personal guaranty could attempt to structure the guaranty in such a way to harmonize the self-interest of the insider with those of the other creditors. 86 Even though personal guaranties implicate fiduciary duties and bankruptcy policy, they should continue to be an excellent deterrent (at least psychologically) until they are expressly prohibited by statute or until courts begin to strongly strike these provisions down. 87 See Harold S. Novikoff & Barbara S. Kohl, Bankruptcy “Proofing”: Bankruptcy Remote Vehicles and Bankruptcy Waivers, SD24 A.L.I.–A.B.A. 143 (1998). 88 See Marshall E. Tracht, Contractual Bankruptcy Waivers: Reconciling Theory, Practice, and Law, 82 CORNELL L. REV. 301, 309 (1997) [hereinafter Tracht, Waivers]. 89 See id. 90 See id. It should be noted, however, that a unanimous or supermajority vote requirement would not prevent involuntary bankruptcy filings by general partners. See 11 U.S.C. § 303(b)(3) (2000); see also discussion infra Part III.B. 91 See Gregory A. Tselikis, “Bankruptcy-Proofing” Your Commercial Transaction: Reality or Myth?, 13 ME. B.J. 234, 234 (1998). In creating any remote vehicle, the creditor must structure the organizations governing documents in such a way so that (1) the “independent” director cannot be removed by the other members and (2) that new directors cannot be added without the consent of the independent director so as to create a supermajority. Creditors can insure this protection through a very carefully crafted organizational agreement. They can also add terms to their loan that will make the entire balance immediately due if the “independent” voter is removed or if more directors are added to the board so as to create a supermajority that is independent of the “independent” director. 92 See id. at 234. FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 67 the “independent voter” to breach its fiduciary duties to the 93 company and third-party creditors. As such, creditors may find it difficult to fill the role of independent voter because both the creditor and the voter face significant consequences if the court finds wrongdoing on the part of either.94 Another serious concern with remote vehicles is that creditors who require the supermajority or unanimous consent could be deemed “insiders” of the debtor company.95 In the case of either a corporation or partnership, the “independent” designee would most 93 See id. at 234-35; see also supra Part I.B-C. 94 See Tselikis, supra note 91, at 235. (Tselikis points out several reasons why creditors and “independent” voters may want to seriously consider the implications of their actions. First, both the creditor and “independent” designee are subject to substantial liability and/or punitive damages. Second, attorneys should be particularly wary of playing the role of the independent designee because of the serious ethical dilemmas created by the conflicting fiduciary duties). “No man can serve two masters.” Matthew 6:24. 95 It has been questioned whether “the designation of an independent director by a creditor can render the creditor an ‘insider’ for preference purposes.” Novikoff & Kohl, supra note 2, at 4. The Bankruptcy Code defines “insider” as follows: (31) “insider” includes— (A) if the debtor is an individual— (i) relative of the debtor or of a general partner of the debtor; (ii) partnership in which the debtor is a general partner; (iii) general partner of the debtor; or (iv) corporation of which the debtor is a director, officer, or person in control; (B) if the debtor is a corporation— (i) director of the debtor; (ii) officer of the debtor; (iii) person in control of the debtor; (iv) partnership in which the debtor is a general partner; (v) general partner of the debtor; or (vi) relative of a general partner, director, officer, or person in control of the debtor; (C)if the debtor is a partnership— (i) general partner in the debtor; (ii) relative of a general partner in, general partner of, or person in control of the debtor; (iii) partnership in which the debtor is a general partner; (iv) general partner of the debtor; or (v) person in control of the debtor; (D) if the debtor is a municipality, elected official of the debtor or relative of an elected official of the debtor; (E) affiliate, or insider of an affiliate as if such affiliate were the debtor; and (F) managing agent of the debtor; 11 U.S.C. § 101(31) (2000). FIELDING.FMT.DOC 3/3/2005 12:04 PM 68 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 likely be a director, officer, or general partner of some sort. (In the case of an LLC, the designee would be a member or the managing director). Regardless of the exact position, the designee likely would qualify as an “insider” under the Bankruptcy Code.96 Thus, the critical issue would be whether the “insider” status of the “independent” designee could be attributed to the creditor through the principal-agent relationship. This is obviously a very fact specific question, but it is one that creditors who demand the “independent” designee should be extremely cautious about. Given the right set of circumstances, the Bankruptcy Code allows the trustee to void transfers made to creditors up to one year before the bankruptcy filing.97 Thus, a creditor that has used the independent designee to obtain collateral could ultimately be forced to return the collateral to the debtor. A simple hypothetical will illustrate this point. Secured Creditor obtains a security interest in collateral purchased by company using funds loaned by the creditor. To protect itself, the creditor requires that the company amend its governing documents such that a unanimous vote is required to file for bankruptcy. The creditor then appoints an “independent” designee to serve as one of the company’s voting directors. Over time, the collateral depreciates so that the creditor’s claim is partially secured. Simultaneously, the company experiences difficult financial times and is forced to consider bankruptcy. Believing that it would be more efficient to simply foreclose the loan and obtain the collateral, the creditor instructs the independent agent to block any attempted bankruptcy filing. The creditor then forecloses on the collateral and has it repossessed. Six months later, the company files for bankruptcy. (The bankruptcy filing could be accomplished by (1) the departure of the independent agent after the collateral has been repossessed or (2) the company convincing other creditors to file an involuntary petition). Once in bankruptcy, the company would seek to have the transfer to the bank rescinded on the grounds that the bank was an “insider.” This simple hypothetical illustrates two important points. First, creditors that demand a supermajority or unanimous consent for 96 See 11 U.S.C. § 101(31). A judge would most likely rule that a member of an LLC is also an insider under the Bankruptcy Code even though the Code does not have any definition of “insider” that clearly includes a member. 97 See id. § 547(b). FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 69 bankruptcy must ensure that the “independent” designee remains a voting member for at least one year beyond the time when the 98 collateral is actually repossessed. Such a move would prevent the possibility of the creditor being deemed an insider of the company.99 Second, even if the designee remains with the debtor company, the creditor still runs the risk of a voided transfer if other creditors can force an involuntary bankruptcy and prove that the creditor was an 100 insider before the one year passes. Thus, creditors who require “independent” company directors inevitably run the risk of being deemed insiders of the debtor company. There is at least one more downside to bankruptcy remote vehicles. Companies and their managers or owners who enter into agreements requiring a supermajority or unanimous consent for bankruptcy could face claims from other unsecured creditors for breach of fiduciary duty because the company has intentionally limited its ability to pay other creditors.101 In the context of an LLC, this concern is particularly pointed because the LLC liability shield would not protect the member for his personal breach of fiduciary duties. Simply stated, bankruptcy remote vehicles may be easily implemented, but they are fraught with real dangers to both the creditor and debtor. Creditors face the difficult task of finding an independent designee who is willing to risk personal breaches of a fiduciary duty. Creditors also run the risk of being deemed insiders of the company and subsequently losing any collateral they may have repossessed. Debtors also face claims of fiduciary duty violations for any preferences given to the domineering creditor. Taken together, the heavy risks stemming from bankruptcy remote vehicles apparently outweigh any benefit from these unique devices. C. Bad Faith Stipulation Another hindrance mechanism is to require the debtor to agree that any bankruptcy filing would be in “bad faith” and to seek 98 Otherwise they risk an avoidance of any transfers by the trustee under § 547(b). 99 See 11 U.S.C. § 547(b). 100 An involuntary filing could be orchestrated by an insider inducing the company’s creditors to file an involuntary petition. See, e.g., In re Kingston Square Assocs., 214 B.R. 713 (Bankr. S.D.N.Y. 1997). An involuntary petition may also be available for LLCs under the provisions of 11 U.S.C. § 303(b)(3). See infra Part III.B. 101 See Tselikis, supra note 91, at 234, 236. FIELDING.FMT.DOC 3/3/2005 12:04 PM 70 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 a dismissal of the petition.102 While there are cases indicating that 103 the “bad faith” agreement is binding, a more recent decision from Florida indicates that the bad faith agreement, standing alone, will be insufficient to establish the bad faith required for dismissal.104 Thus, an alternative to an outright “bad faith” agreement is to simply require the debtor to stipulate to findings of fact that would increase the likelihood of a dismissal by the court for a bad faith 105 filing. While stipulated facts increase the likelihood of a dismissal, creditors and debtors must be wary because they could be accused of a Rule 11 violation for making misrepresentations to the court.106 As such, the bad faith stipulation agreement is a viable alternative if the stipulated facts are indicative of the real situation. D. Pre-petition Waiver of the Automatic Stay Another pre-petition option is to require the debtor to waive the automatic stay protections once bankruptcy is filed.107 When a debtor files for bankruptcy, all of its creditors are enjoined from commencing or continuing proceedings against the debtor, enforcing judgments, filings liens, etc.108 The court may grant relief from a stay for a particular creditor after notice, a hearing, and a 109 finding of cause. Thus, the practical effect of this relief is to allow the creditor to pursue—at least in some limited form—its claims against the debtor. Obviously, creditors that could obtain and 102 Novikoff & Kohl, supra note 2, at 11-12. 103 See id. (citing In re University Commons, 200 B.R. 255, 259 (Bankr. M.D. Fla. 1996); In re Aurora, 134 B.R. 982, 985 (Bankr. M.D. Fla. 1991); In re Orange Park S. P’ship, 79 B.R. 79, 82 (Bankr. M.D. Fla. 1987). Novikoff and Kohl note that each of these cases involved both the “bad faith” agreement plus the normal indications of a bad faith filing. Thus, reliance upon these cases for establishing the per se validity of a “bad faith” agreement seems tenuous at best. 104 See Novikoff & Kohl, supra note 2, at 12 (citing In re S. E. Fin. Assocs., 212 B.R. 1003, 1005 (Bankr. M.D. Fla. 1997). 105 See Tracht, Waivers, supra note 88, at 310. 106 See Fed. R. Civ. P. 11(b) (“By presenting to the court . . . [stipulated facts], an attorney . . . is certifying that to the best of the person’s knowledge, information, and belief, formed after an inquiry reasonable under the circumstances, . . . (3) the allegations and other factual contentions have evidentiary support”). 107 See Novikoff & Kohl, supra note 2, at 12-13. For an excellent article regarding bankruptcy treatment of waivers of the automatic stay provision, see Sally S. Neely, Prepetition Waivers of the Automatic Stay: Are they Enforceable?, SE71 A.L.I.–A.B.A. 17 (Feb. 24, 2000). The specific provisions governing automatic stays are found at 11 U.S.C. § 362 (2000). 108 11 U.S.C. § 362(a)(2000). 109 Id. § 362(d). FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 71 enforce a waiver of the automatic stay are in a better position than other creditors because the debtor cannot avail itself of all the protections of a bankruptcy filing. Although courts generally agree that any creditor with an automatic stay waiver must petition the 110 court in accordance with 11 U.S.C. § 362, there is a sharp split as to whether waivers of the automatic stay are enforceable.111 In regards to LLCs, a pre-petition waiver of the automatic stay would likely yield the same results as with a corporation or partnership because the waiver has no real bearing on the company’s structure. E. Abstention A final pre-petition hindrance mechanism is to require the debtor to seek court abstention once a bankruptcy petition has been filed. The Bankruptcy Code allows the court to dismiss or suspend a case if the interests of the creditors and the debtor are best served by the action.112 An agreement requiring the debtor to automatically seek a dismissal under § 305 would probably be void for the same reasons that a debtor cannot waive the right to file for bankruptcy.113 However, requiring the debtor to simply seek a temporary court abstention is more likely to succeed because (1) 110 See Novikoff & Kohl, supra note 2, at 13 (citing In re Shady Grove Tech Ctr. Assocs., 216 B.R. 386, 393-94 (Bankr. D. Md. 1998); In re Darrell Creek Assocs., 187 B.R. 908, 910 (Bankr. D.S.C. 1995); In re Powers, 170 B.R. 480, 483 (Bankr. D. Mass 1994); In re Cheeks, 167 B.R. 817, 818-19 (Bankr. D.S.C. 1994); In re Sky Group Int’l, Inc., 108 B.R. 86, 89 (Bankr. W.D. Pa. 1989); In re S. E. Fin. Assocs., 212 B.R. 1003, 1005 (Bankr. M.D. Fla. 1997)(dicta)). 111 See Novikoff & Kohl, supra note 2, at 13. Novikoff and Kohl cite numerous cases holding that automatic stay waivers are or are not enforceable. See, e.g., In re Shady Grove Tech Ctr. Assocs., 216 B.R. 386, 393-94 (Bankr. D. Md. 1998) (automatic stay waivers are enforceable); see also In re Atrium High Point L.P., 189 B.R. 599, 608 (Bankr. M.D.N.C. 1995); In re Darrell Creek Assocs., 187 B.R. at 910; In re Cheeks, 167 B.R. at 818; In re Powers, 170 B.R. at 484; In re McBride Estates, Ltd., 154 B.R. 339, 343 (Bankr. N.D. Fla. 1993); In re Citadel Props., Inc., 86 B.R. 275, 276 (Bankr. M.D. Fla. 1988); but see In re Pease, 195 B.R. 431, 433 (Bankr. D. Neb. 1996) (automatic stay waivers are not enforceable); see also In re Jenkins Court Assocs., 181 B.R. 33, 37 (Bankr. E.D. Pa. 1995); Farm Credit of Cent. Fla. v. Polk, 160 B.R. 870, 873-74 (M.D. Fla. 1993); In re Sky Group Int’l, Inc., 108 B.R. at 89. 112 11 U.S.C. § 305(a) (2000). Section 305(a) specifically provides: (a) The court, after notice and a hearing, may dismiss a case under this title, or may suspend all proceedings in a case under this title, at any time if— (1) the interests of creditors and the debtor would be better served by such dismissal or suspension . . . . 113 Novikoff & Kohl, supra note 2, at 11 (discussing why a waiver of the right to file for bankruptcy is void). FIELDING.FMT.DOC 3/3/2005 12:04 PM 72 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 the debtor is not deprived of the right to file for bankruptcy,114 (2) the out-of-court workout might actually be more beneficial for both 115 the debtor and creditors, and (3) the abstention promotes judicial economy and saves litigation costs. To increase the likelihood of a court suspension, the creditor could require that the debtor stipulate to various facts. However, such a requirement may border on a Rule 11 violation if the stipulated facts are not completely accurate or if the debtor’s best interest would be to remain in the bankruptcy proceedings.116 Arguably, debtors are more inclined to sign an abstention agreement (as opposed to a waiver of the automatic stay) because their rights and interests are not restricted as much. Furthermore, the biggest advantage a creditor could hope to gain from such an agreement is an increased amount of time before the bankruptcy proceedings have their full effect. Increased time, in turn, might provide the key element to further minimizing a creditor’s debt or to successfully turning around the struggling debtor. Of course, the creditor also faces a potential downside: the collateral may continue to depreciate in value during the abstention period. Another advantage of a § 305 abstention mechanism is that a suspension or dismissal of a case cannot be appealed.117 Thus, a creditor that can convince a court to suspend the proceedings is insured of a temporary period of no bankruptcy proceedings. Of course, the abstention rule cuts both ways and a court’s decision to not dismiss or suspend a case cannot be appealed either.118 Given the workings of § 305, a creditor’s course seems clear: the creditor 114 The court’s order of dismissal could be without any prejudice such that the debtor could re-file if a non-bankruptcy workout proved to be infeasible. Furthermore, the suspension of the proceedings could be conditioned on the occurrence (or absence) of various conditions such that the bankruptcy proceedings could be easily reinstated if the workout was unsuccessful. 115 See Novikoff & Kohl, supra note 2, at 15 (discussing In re Colonial Ford, Inc., 24 B.R. 1014 (Bankr. D. Utah 1982)). 116 See discussion, supra Part II.C. regarding Rule 11 violations for requiring stipulated facts for a waiver of the automatic stay. 117 11 U.S.C § 305(c) (2000) specifically provides: (c) An order under subsection (a) of this section dismissing a case or suspending all proceedings in a case, or a decision not so to dismiss or suspend, is not reviewable by appeal or otherwise by the court of appeals under section 158(d), 1291, or 1292 of title 28 or by the Supreme Court of the United States under section 1254 of title 28. 118 See 11 U.S.C. § 305(c). FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 73 should generally attempt to have the case dismissed or suspended. If the creditor prevails, then it gets the advantage of a dismissed case or a period of time without the bankruptcy proceedings. If the creditor fails, then it is in the same position as if no motion was ever filed. III. CLASSIFICATION OF AN LLC ONCE A BANKRUPTCY IS FILED Despite sophisticated attempts to implement bankruptcy hindrance mechanisms, an LLC may nevertheless voluntarily file for bankruptcy or be the subject of an involuntary petition. Any LLC bankruptcy filing creates an immediate problem: the Bankruptcy Code has not been amended to deal with the unique features of the limited liability company. Currently there are no statutes or case law to help determine whether an LLC should be considered a corporation or a partnership in bankruptcy. A limited liability company’s classification is an important consideration for both creditors and debtors because the classification could impact a creditor’s future posture as the bankruptcy progresses.119 This section addresses these classification issues in the context of the initial bankruptcy filing. A. Eligibility In all likelihood an LLC will be deemed eligible to file under the Bankruptcy Code.120 However, its classification as an eligible entity may ultimately affect the company’s rights as the bankruptcy case progresses. The Bankruptcy Code requires that an entity qualify as a “person” to file a bankruptcy petition.121 The term 119 See e.g., 11 U.S.C. § 303(b)(3) (involuntary filings only permitted for partners and not allowed for corporate shareholders); § 502(a) (creditor of a general partner in a partnership that is a debtor in a chapter 7 case may object to a proof of claim); § 508(b) (creditor of partnership in chapter 7 who receives payments from a general partner for an unsecured claim cannot receive the payment until the other unsecured creditors receive a payment equal to that given by the general partner); § 723(a) (trustee may have claims against the general partner of a partnership). 120 It has been noted that, “[v]irtually anyone or anything can be a debtor in a bankruptcy proceeding.” Anthony Michael Sabino, Litigation Issues for the Limited Liability Company, 69-Feb N.Y. ST. B.J., 30, 31 (Feb. 1997). 121 11 U.S.C § 109(a) (2000); see also The Best Entity for Doing the Deal: Limited Liability Companies and Bankruptcy, 937 P.L.I./Corp. 747, 763 (Apr.-May 1996) [hereinafter Best Entity]. FIELDING.FMT.DOC 3/3/2005 12:04 PM 74 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 “person” includes, but is not limited to, individuals, partnerships, 122 and corporations. Because this definition is not limited to the specifically enumerated entities, it probably would include an LLC.123 Given traditional limitations on the term “person,” courts will likely determine that an LLC meets the threshold definitional 124 requirement. It should be noted, however, that there are no reported cases holding that an LLC constitutes a “person” under the Bankruptcy Code. Thus, the weak technical argument remains that an LLC is not eligible to file for bankruptcy because it is not a “person.” Until the Code is amended to specifically address LLCs, courts must decide whether to classify limited liability companies as corporations or partnerships for purposes of the bankruptcy proceedings. At least two commentators disagree about the impact that occurs to an LLC if it is determined to constitute a “corporation” during the bankruptcy proceedings. James J Wheaton argues that the impact is minimal. It is also worth observing that the classification of an LLC as a partnership or as a corporation for purposes of determining the applicability of the Bankruptcy Code should have little other effect on the disposition of a bankruptcy proceeding. Most of the provisions of the Bankruptcy Code that apply specifically to partnerships relate to issues, such as the liabilities of general partners, that are not likely to apply in an LLC context.125 In contrast, it has been suggested that the definitional classification could affect the court’s treatment of the LLC— particularly if the LLC is set up to closely resemble a partnership. A court may hesitate to conclude that an LLC is a corporation because the definition of corporation specifically excludes the limited partnership, an entity that resembles the LLC. A court may also wish to avoid characterizing the LLC as a corporation because an LLC 122 See 11 U.S.C. § 101(41). (Section 101(41) specifically provides: “person” includes individual, partnership, and corporation, but does not include governmental unit, [with some exceptions for the governmental unit]). The Bankruptcy Code’s Rules of Construction state that the terms “includes” and “including” are not limiting. 11 U.S.C. § 102(3). 123 See 11 U.S.C. §§ 101(41), 102(3); see also Best Entity, supra note 121, at 763-64. 124 Best Entity, supra note 121, at 764-65. 125 James J. Wheaton, Square Pegs in Round Holes: LLCs Under Other Statutes, Q287 A.L.I.- A.B.A. 49, 51 (Mar. 25, 1999). FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 75 managed by its members resembles a general partnership more closely than a corporation. A court may therefore wish to treat this type of LLC as a partnership for certain purposes under the Bankruptcy Code—such as determining the method of filing a petition, determining the venue of the case, and determining the members’ fiduciary duties. It is thus more expedient for a court to simply conclude that an LLC is eligible for relief without tying the entity to the definition of corporation.126 While it is easy to simply call an LLC a “person” without determining what kind of a person it is (i.e., a partnership or corporation), there still are certain situations where the Court must determine if the LLC is more like a partnership or a corporation 127 under the Bankruptcy Code. Because a corporation constitutes a “person” under the Bankruptcy Code,128 a court could determine that an LLC 129 constitutes a “corporation” when determining its eligibility to file. Such a conclusion would resolve future problems whether to treat the LLC like a partnership or corporation. The Code’s expansive definition of “corporation” includes two possible categories under which an LLC could qualify: (ii) [a] partnership association organized under a law that makes only the capital subscribed responsible for the debts of such association . . .; and (iv) [an] unincorporated company or association.130 An LLC appears to qualify as a “corporation” under both of these definitions.131 Thus, a 126 Best Entity, supra note 121, at 766-67 (citations omitted). 127 Examples where the classification as a partnership or corporation would be important include: 11 U.S.C. § 303(b)(3) (involuntary filings only permitted for partners and not allowed for corporate shareholders); § 502(a) (creditor of a general partner in a partnership that is a debtor in a chapter 7 case may object to a proof of claim); § 508(b) (creditor of partnership in chapter 7 who receives payments from a general partner for an unsecured claim cannot receive the payment until the other unsecured creditors receive a payment equal to that given by the general partner); § 723(a) (trustee may have claims against the general partner of a partnership). 128 See 11 U.S.C. § 101(41) (2000). 129 Best Entity, supra note 121, at 765. 130 11 U.S.C. § 101(9)(A)(ii), (iv). 131 See Wheaton, supra note 125, at 51; see also Best Entity, supra note 121, at 764-67; Aileen R. Leventon, Securities and Bankruptcy Law Issues Relating to Limited Liability Companies, 836 P.L.I./Corp. 671, 680-81 (Jan.-Mar., 1994). FIELDING.FMT.DOC 3/3/2005 12:04 PM 76 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 purely legal interpretation of the Code suggests that an LLC should be considered a corporation for bankruptcy purposes. In contrast, the equitable approach suggests that an LLC should be treated as a partnership because the company will often be structured exactly like a partnership. There is “wiggle” room under the Code’s definition whereby in limited circumstances an LLC could be deemed to be a partnership for bankruptcy purposes. For example, the Bankruptcy Code specifically excludes a “limited partnership” from the definition of “corporation.”132 Furthermore, the Code does not define a “limited partnership,” so entities that constitute a limited partnership will be based upon a state law definition of that term. Thus, a creative litigant could argue that an LLC should be treated as a partnership if the state law definition of “limited partnership” could be broadly construed to include an LLC. Indeed, the malleability of the LLC laws should enable the business entity to be structured to directly resemble a limited partnership with the liability shield of an LLC. Obviously, this is a very fact specific issue that practitioners need to carefully consider in light of existing state law. B. Involuntary Bankruptcy Petitions Knowledge of how involuntary bankruptcy petitions operate is necessary to understand all the actions that creditors and debtors may take in favoring or opposing an attempted bankruptcy filing. A corporate debtor’s involuntary bankruptcy is commenced when three or more of its creditors file a petition in the bankruptcy 133 court. These creditors must hold an aggregate unsecured claim of at least $10,775,134 and each claim cannot be contingent135 or the 132 See 11 U.S.C. § 101(9)(B). 133 See id. § 303(b)(1). 134 Although the aggregate unsecured claim must total $10,775, the debtor does not need to be totally unsecured. For example, a debtor who has a claim of $12,000 that is secured by collateral totaling $7,000 will have a secured claim of $7,000 and an unsecured claim of $5,000. The unsecured claim of $5,000 can be added to the aggregate of unsecured claims. See CHARLES JORDAN TABB, THE LAW OF BANKRUPTCY, § 2.3 (1997). 135 [C]laims are contingent as to liability if the debt is one which the debtor will be called upon to pay only upon the occurrence or happening of an extrinsic event which will trigger the liability of the debtor to the alleged creditor and if such triggering event or occurrence was one reasonably contemplated by the debtor and creditor at the time the event giving rise to the claim occurred. In re All Media Props., Inc., 5 B.R. 126, 133 (Bankr. S.D. Tex. 1980), aff’d, In re All Media FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 77 subject of a bona fide136 dispute.137 If the debtor has less than twelve creditors, then one or more creditors may file an involuntary petition as long as they have non-contingent, bona-fide unsecured claims totaling $10,775.138 Employees, insiders, and entities holding a voidable transfer cannot have their claims aggregated if there are 139 less than twelve creditors. In contrast to a corporate bankruptcy, an involuntary bankruptcy may also be commenced by one or more general partners in a partnership.140 Any general partner that did not join in the involuntary petition may file an answer in response to the 141 petition. A partnership may also be forced into involuntary bankruptcy by creditors having non-contingent, bona-fide claims totaling $10,775.142 Why may general partners, acting individually, file an involuntary petition while shareholders in a corporation do not enjoy this same right? It has been suggested that individual partners are given the right to file an involuntary petition because they face Props., Inc., 646 F.2d 193 (5th Cir. 1981). In other words a contingent claim is one that is dependent upon the occurrence of a future event. The contingency must deal with the liability in general and not the amount of the liability; unmatured or unliquidated debts are not contingent. See TABB, supra note 134, at § 2.3. 136 A “bona fide dispute” has been interpreted by several courts as constituting a factual or legal dispute as to the validity of a debt, and the court only needs to determine if there is actually a dispute (and not its outcome). See, e.g., Rimell v. Mark Twain Bank (In re Rimell), 946 F.2d 1363, 1365 (8th Cir. 1991); Bartmann v. Maverick Tube Corp., 853 F.2d 1540, 1544 (10th Cir. 1988); In re Busick, 831 F.2d 745, 750 (7th Cir. 1987); MAG Bus. Servs. Bentley Racing Prods. v. Whiteside (In re Whiteside), 238 B.R. 468, 469 (Bankr. W.D. Mo. 1999); In re Ramm Indus., 83 B.R. 815, 822 (Bankr. M.D. Fla. 1988). The procedure for determining a bona fide dispute is relatively simple. A creditor filing an involuntary bankruptcy must prove a prima facie case of no bona fide dispute. In re Rimell, 946 F.2d at 1365. If this is done, the debtor must then prove that there is an actual dispute over the claim. Id. Although the court will not resolve the dispute, it may, out of necessity, conduct a limited analysis of the underlying legal claims and factual disputes. Id. Often, the resolution of the bona fide dispute will require that the bankruptcy court make a factual finding based upon witness credibility whether there is a bona fide dispute. Id. This factual finding can only be reversed on appeal under the clearly erroneous standard. Id. 137 See 11 U.S.C. § 303(b)(1) (2000). 138 See id. § 303(b)(2). 139 See id. 140 See id. § 303(b)(3)(A). Note that one of the general partners or the trustee of a general partner may also unilaterally file an involuntary bankruptcy for a general partnership if a court has ordered a bankruptcy with respect to all of the general partners in the partnership. See id. § 303(b)(3)(B). 141 See 11 U.S.C. § 303(d). 142 See id. § 303(b). FIELDING.FMT.DOC 3/3/2005 12:04 PM 78 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 increasing personal liability if the partnership bankruptcy is 143 delayed. In contrast, a shareholder’s liability is almost always limited to the amount of their investment. Thus, a shareholder faces no increased liability if bankruptcy is delayed. If personal liability is the controlling rationale for this rule, then individual LLC members should not be able to unilaterally file an involuntary petition because they do not face increased liability from a delayed bankruptcy filing.144 However, the personal liability rationale does not squarely address the issues faced by LLCs and their members. LLCs are typically owned by a few individuals rather than a large number of people (as is often the case for corporations). Because ownership is often concentrated in the hands of just a few people, each of the LLC members often actively participate in the company’s operations. While it is true that they do not face personal liability for simply being members of the company, they are nevertheless subject to fiduciary obligations that directly stem from their roles in the LLC.145 Furthermore, there is a strong argument that the LLC members cannot contractually escape all liability for their fiduciary 146 responsibilities. This is particularly true in regards to the general creditors once the company becomes insolvent. Given this unique aspect of LLCs, there remains a strong argument that individual members should be granted the right to file an involuntary bankruptcy petition just as a general partner may do. Indeed, this rationale becomes even more persuasive in the face of bankruptcy hindrance mechanisms. As noted above, bankruptcy hindrance mechanisms often implicate the fiduciary responsibility of an LLC member. In an LLC owned and operated by two members, a hindrance mechanism may drive one member to not seek bankruptcy while the other member feels compelled by his fiduciary obligations to file for the proceeding. If the LLC member is not allowed to file involuntarily, then he would be subjected to continuing violations of his fiduciary duty. Such a result is clearly inequitable. However, this entire “equitable” argument for treating LLCs like partnerships ignores one critical fact: there are a large number 143 See Neely, supra note 9, at 288. 144 See id. 145 See supra Part I.B. 146 See supra Part I.B. FIELDING.FMT.DOC 3/3/2005 12:04 PM 2001] Limited Liability Companies 79 of small, closely held corporations that practically function like a partnership, and yet the Bankruptcy Code creates no special or “equitable” protection for these small entities. Often these corporations involve just two or three individuals who opted for the corporate entity to protect their own personal liability. Indeed, where two or three individuals entirely own a corporation and serve as its officers and directors, these people are subjected to the same temptations to breach fiduciary duties owed to the corporation, its shareholders, and the company’s general unsecured creditors (when the company becomes insolvent). This fact existed long before the LLC ever gained any prominence, and yet the bankruptcy rules have remained the same. Arguing that an LLC should be treated like a partnership simply because it resembles a partnership ignores the fact that small, closely held corporations which are practically operated as a partnership enjoy no such benefit. Indeed, this argument further strengthens the suggestion that an LLC should be treated as a corporation in bankruptcy because that is what it most closely resembles in both form and practice. Thus, the real problem with 11 U.S.C. § 303(b) is that it subjects the shareholders and directors of small corporations to personal liability if the other shareholders and directors of the company refuse to file a bankruptcy petition. If the controlling rationale for only allowing involuntary filings by partners is the threat of increased personal liability,147 then the Code should be modified to protect both small corporations and LLCs whose members face potential personal liability. Such a modification would be beneficial in at least two ways. First, it would be a logical change to the code that reflects the fact that partners face personal liability while shareholders and LLC members do not. Second, such a modification would lend greater weight to the argument that an LLC should be treated like a corporation under the Code because its legal protections are more akin to the corporate entity rather than a partnership. However, until the Bankruptcy Code is amended to address these inherent problems, both creditors and debtors have leeway to argue that individual LLC members have the right to unilaterally file an involuntary petition. 147 See Neely, supra note 9, at 288. FIELDING.FMT.DOC 3/3/2005 12:04 PM 80 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 18 CONCLUSION The advent of the limited liability company will likely go down in history as a major step in American jurisprudence for business entities. The combination of partnership-like taxation coupled with corporate-like liability protection will continue to be the preferred form of business. As more and more LLC companies come into existence, both legislatures and courts will need to develop well thought-out rules to govern these relatively new entities. One of the areas that will need particular attention will be the field of bankruptcy where there are no statutory guidelines as of yet. As illustrated in this Article, there are a number of bankruptcy hindrance mechanisms that creditors may employ to deter unwanted bankruptcy filings. However, these unique contractual creations are often fraught with dangers involving attempted waivers of non-waivable rights. These mechanisms also often implicate the fiduciary responsibilities of individual LLC members. Accordingly, both creditors and debtors should carefully consider whether or not they are in violation of a fiduciary duty (either contractual or legal) when implementing a bankruptcy hindrance device. Finally, the structure of the current bankruptcy code suggests that LLCs should be treated as corporations when filing for bankruptcy. However, the practical effect of this classification could potentially subject LLC members to increased liability through continuing breaches of the fiduciary duty. Congress, States, and the courts must address these pressing issues to create a clear cut set of rules under which debtor LLCs and creditors may comfortably operate.
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