By Daniel W. Glasser on January 16, 2024.
Introduction
It is no secret that Bankruptcy can turn everything we know about the law on its head. And when that happens in the realm of limited liability company (“LLC”) governance, investors, bankers and lawyers should pay attention. Free markets depend on predictability. Indeed, Delaware is often favored as a venue for LLC formation precisely because lawyers hope to find a measure of predictability in Delaware’s extensive body of statutory and judicial law governing LLCs. But it is important to know how to ensure managerial continuity—especially if one of the members files for bankruptcy.
When a company manager files for bankruptcy protection, at least one court has found Delaware statutory law irrelevant. Last month (December 2023), the Bankruptcy Court for the Southern District of Texas (applying Delaware law) in In re Envision Healthcare Corp., summarily dispensed with a statute governing the management of Delaware LLCs. [1] The Envision Healthcare Court held that Section 18-304 of the Delaware Limited Liability Company Act (the “Del. LLC Act”) does not allow a bankrupt member to be relieved of managerial and voting rights in a Delaware LLC upon filing for bankruptcy—despite a provision in the Del. LLC Act which says exactly that. This marks an important departure from established law.
Bankruptcy courts, however, are generally deferential to arms-length agreements made by and between members of an LLC. With this in mind, it seems the best way to guard against the uncertainty created by Envision Healthcare is to incorporate into operating agreements provisions that address the bankruptcy of a member—even if state law already resolves this issue by default. In other words, it may not be enough for members or entities to rely on the “default” position outlined in a state’s LLC statutes when a fellow member files for bankruptcy.
Background
The Right to Manage an LLC is Critically Important
Before we get into the nuts-and-bolts of Envision Healthcare, it is important to address the broader question of company “management.” Who exactly has authority to make decisions for an LLC? This is, of course, the most important question equity owners typically ask. And when they find themselves embroiled in business divorce litigation, it is certainly a question the lawyers will have to answer.
In Colorado, LLC members can (and usually do) sign an “operating agreement” detailing their respective rights and responsibilities. Otherwise, if they have no operating agreement, or if not addressed in the operating agreement, the provisions of the Colorado Limited Liability Company Act (the “Colorado LLC Act”) control. C.R.S. § 7-80-108(1)(a).
Again, when it comes to the conduct of LLC affairs, predictability is key. Owners need to know who is allowed to vote and on which issues. They also need to know how new members may be admitted, whether existing members can be removed and, if so, on what basis. But even if these issues are addressed in writing, life events can upset the applecart. Members of the LLC may die or become incapacitated. Or, a member may file for bankruptcy.
Different states treat a member filing for bankruptcy differently. The Colorado LLC Act does not address what happens if a member files for bankruptcy. So, owners will typically address this in their operating agreement. It is not uncommon, for example, to see an operating agreement which provides that any member who files for bankruptcy will retain their economic interest in the company but lose the right to vote. In Delaware, by contrast, this conceptual framework is a matter of statutory law:
A person ceases to be a member of a limited liability company upon the happening of any of the following events:
(1) Unless otherwise provided in a limited liability company agreement, or with the consent of all members, a member:
-
- Makes an assignment for the benefit of creditors;
- Files a voluntary petition in bankruptcy;
- Is adjudged a bankrupt or insolvent, or has entered against the member an order for relief, in any bankruptcy or insolvency proceeding;
- Files a petition or answer seeking for the member any reorganization, arrangement, composition, readjustment, liquidation, dissolution or similar relief under any statute, law or regulation;
- Files an answer or other pleading admitting or failing to contest the material allegations of a petition filed against the member in any proceeding of this nature;
- Seeks, consents to or acquiesces in the appointment of a trustee, receiver or liquidator of the member or of all or any substantial part of the member’s properties . . .
6 Del. C. § 18-304 (emphasis added).
Under Delaware law, even though a person will lose their membership status if they file for bankruptcy protection, they retain their economic interests. Indeed, Delaware courts have held that Section 18-304 cannot deprive a member of a limited liability company of the member’s economic rights in the company upon the filing of bankruptcy: “Essentially, . . . § 18-304 means that a member who files for bankruptcy still ceases to be a member, but becomes an assignee with the economic rights specified in § 18-702(b).” Milford Power Co., LLC v. PDC Milford Power, LLC, 866 A.2d 738, 762 (Del. Ch. 2004).
The Law Favors Enforcement of Agreed Terms
This is the outcome most would expect, not only in Delaware but in places like Colorado. LLC operating agreements are typically treated by courts as enforceable contracts. And where the terms are clear, judges are apt to enforce the plain meaning of the agreement. For now, it seems that this “plain language” approach is the law in the Tenth Circuit, even when a bankruptcy court is called upon to enforce provisions that govern the management of an LLC.
The United States Bankruptcy Appellate Panel for the Tenth Circuit (the “B.A.P.”) illustrated this approach in an unpublished case called DB Capital Holdings, LLC v. Aspen HH Ventures, LLC.[2] There, the central question was whether the company’s operating agreement allowed the debtor to file for bankruptcy in the first place.[3] The entity, DB Capital, was formed to develop real estate in Aspen, Colorado.[4] After DB Capital defaulted on its secured loan, its Class A member, Aspen HH Ventures (“Aspen HH”) asked the state court to dissolve the entity.[5] Thereafter, a separate Class B member, Dancing Bear Management, LLC (“Manager”), filed a voluntary Chapter 11 bankruptcy case on behalf of DB Capital in violation of the company’s operating agreement.[6]
. . .existing case law does not support “the proposition that members of an LLC cannot agree among themselves not to file bankruptcy, and that if they do, such agreement is void as against public policy.”
Aspen HH immediately moved to dismiss the bankruptcy proceedings.[7] It argued that the Manager had filed the case in bad faith and that the company’s operating agreement precluded DB Capital from initiating bankruptcy proceedings in the first place.[8] In response, the Manager argued that the operating agreement’s attempt to preclude a bankruptcy filing violates public policy.[9] And, in any event, the prohibition was included in the operating agreement at the behest of (and for the sole benefit of) DB Capital’s secured lender.[10] Indeed, the operating agreement could not even be amended without the lender’s permission.
The Colorado Bankruptcy Court granted Aspen HH’s motion to dismiss the bankruptcy case, which was appealed to the B.A.P.[11] The lower court order was affirmed. According to the B.A.P. in DB Capital, operating agreements can restrict an entity’s ability to commence bankruptcy proceedings.[12] In other words, the members of the limited liability were free to agree amongst themselves—in their operating agreement—to prohibit the company’s managers from filing a bankruptcy petition. While this ruling was unpublished, the Court’s analysis of the Colorado LLC Act provides a valuable roadmap.
The question in DB Capital was whether an operating agreement (a contract) could properly limit the company manager’s authority to file for bankruptcy relief (a statutory right). Under the Colorado LLC Act, the parties’ operating agreement will govern the rights and duties of members and managers. And, in DB Capital, the limitation on managerial authority was explicit:
The Company (v) to [the] extent permitted under applicable Law, will not institute proceedings to be adjudicated bankrupt or insolvent; or consent to the institution of bankruptcy or insolvency proceedings against it; or file a petition seeking, or consent to, reorganization of relief under any applicable federal or state law relating to bankruptcy . . . [13]
Although this limitation was unambiguous, the Manager argued it should not be enforced because public policy disfavors contractual prohibitions on the right to seek relief in bankruptcy court. Indeed, as the Manager pointed out, bankruptcy jurisprudence is replete with cases disregarding contracts that prospectively prohibit a debtor from seeking bankruptcy protection, i.e., the ipso facto rule.[14]
The B.A.P., however, treated the LLC operating agreement as something different than a promissory note or a loan. Banks have historically wielded disproportionate bargaining power vis-à-vis their borrowers. Hence, bankruptcy courts will not enforce ipso facto clauses in loans. In other words, third-party lenders cannot contractually prohibit a borrower from filing for bankruptcy. The DB Capital Court started by rejecting this rule within the context of an operating agreement. As explained by the DB Capital Court, existing case law does not support “the proposition that members of an LLC cannot agree among themselves not to file bankruptcy, and that if they do, such agreement is void as against public policy.”[15]
According to the DB Capital Court, then, the rule against ipso facto clauses only applies to agreements between a debtor and third parties, but not to agreements among members of an LLC.[16] Although the Manager in DB Capital argued that the secured lender had mandated the language limiting the authority to commence a bankruptcy case into the operating agreement, the B.A.P. noted that no evidence was presented to the lower court to support this assertion.[17] Thus, if the record reflected active lender coercion, the outcome may have been different.
DB Capital is an important example of how bankruptcy courts tend to defer to agreements entered into by and amongst members of an entity. But what happens if the members embrace these same protections by relying on an applicable state statute? Delaware statutory law, for instance, provides that a member cannot retain voting rights if that member files for bankruptcy. Because the Del. LLC act provides “gap-filling provisions” when the operating agreement is silent, one might logically assume that the members of a Delaware LLC could embrace this default provision by electing not to address this issue differently in the operating agreement. The Envision Healthcare decision seems to throw this expectation out the window. Hence, it is important to understand the ruling in this case and its implications.
Envision Healthcare Rejects Delaware Statutory Law
The judge in Envision Healthcare, Judge Christopher Lopez, took a very different view of how operating agreements and statutory law should be applied among members when one of them files for bankruptcy. In that case, equity owners were fighting for control of a subsidiary—namely a Delaware LLC called Folsom Endoscopy Center, LLC (the “Folsom”).[18] One of the owners, AmSurg Holdings, LLC (“AmSurg”) held a 25% interest in Folsom that included managerial and voting interests.[19]
AmSurg initiated a bankruptcy case in May 2023.[20] At the time, pursuant to the Folsom operating agreement, the debtor (AmSurg) held two of five seats on the Folsom board.[21] And the board could not take certain actions without the consent of at least one of the debtor’s (AmSurg) board members.[22]
Judge Lopez described the issue as a “direct conflict” between the Bankruptcy Code and Delaware statutory law.
After AmSurg filed the chapter 11 petition, two of Folsom’s other members amended the company’s operating agreement to strip AmSurg of control.[23] Pursuant to Section 18-304 of the Del. LLC Act, these members did precisely what Delaware law allowed them to do, i.e., relieve a bankrupt member of all management responsibilities.[24] The new, amended operating agreement said that AmSurg no longer held voting or managerial interests in Folsom.[25] And this change was made without input from AmSurg or any other board members.[26]
AmSurg challenged the amendment and argued that the other owners had violated the automatic stay by modifying its voting and management rights under Section 18-304 of the Del. LLC Act.[27] The other members opposed, correctly asserting that Delaware allows for precisely this kind of change if a member files for bankruptcy.
Judge Lopez described the issue presented as a “direct conflict” between the Bankruptcy Code and Delaware statutory law.[28] The members who had amended the Folsom operating agreement argued that there could be no stay violation because Section 18-304 of the Del. LLC Act provides for the automatic loss of a bankrupt member’s voting and management rights. Indeed, the Delaware Chancery court has repeatedly said that the Bankruptcy Code does not preempt Section 18-304.[29] Hence, under Delaware law, the filing of a bankruptcy case strips the debtor of voting and managerial rights while allowing the member to retain its economic interests.
Judge Lopez, however, pointed out that these Chancery court decisions generally overlook Section 541(a)(1) of the Bankruptcy Code. Under that provision, the commencement of a bankruptcy case creates an estate which retains “all legal or equitable interests of the debtor in property as of the commencement of the case.”[30] In contrast to the B.A.P.’s decision in DB Capital, Judge Lopez said that “parties cannot contract around what becomes estate property, and states cannot legislate estate property away.”[31] He found a direct conflict between Section 18-304 of the Del. LLC Act and Bankruptcy Code 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.”[32]
According to Judge Lopez, “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.”[33] 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.”[34]
According to the Envision Healthcare court, the post-bankruptcy amendments made to the Folsom operating agreement (which were consistent with the applicable Delaware statute) violated the automatic stay and were void, as a matter of law. In the words of Judge Lopez, the Delaware statute had to “give way” to Section 541 of the Bankruptcy Code.[35]
Conclusion
The Envision Healthcare decision is framed as a conflict between two statutes—the Delaware LLC Act and the Bankruptcy Code. Perhaps not surprisingly, Judge Lopez (a bankruptcy judge) deferred to the Bankruptcy Code. And it is entirely possible that other bankruptcy courts will view such conflicts the same way.
Nevertheless, bankruptcy courts do tend to prioritize and apply arms-length agreements by and among members.
The only foreseeable way to avoid this perceived conflict among statutes is to make such bankruptcy-dependent managerial issues a matter of contract interpretation. In other words, if the operating agreement in Envision Healthcare had expressly said that a bankrupt member would lose its voting and management rights, the outcome may have been different. Again, the 10th Circuit BAP in DC Capital made clear that it will enforce plain language of a written contract. And that seems to be the case even where the members have made an agreement that limits their rights if they file for bankruptcy relief.
But we do not yet know whether other courts will follow Envision Healthcare’s reasoning when confronted with a conflict between the provisions of an operating agreement and the Bankruptcy Code. Section 541 of the bankruptcy code states that the property of the estate cannot be modified by either non-bankruptcy law or by agreement. See 11 U.S.C. § 541(c)(1)(B). So, a bankruptcy judge—such as Judge Lopez—might well disregard an operating agreement expressly incorporating the protections of 6 Del. § 18-304. Nevertheless, bankruptcy courts do tend to prioritize and apply arms-length agreements by and among members. Thus, we believe the better approach is to explicitly incorporate such provisions into an enforceable operating agreement rather than relying on the default protections of state law.
Again, our recommendation—especially for lawyers involved in the formation of Delaware LLCs—is to expressly incorporate the provisions of Section 18-304, or similar state law protections, into an operating agreement. Otherwise, your clients may run the risk of a bankruptcy court summarily dispensing with the default provisions of state statutory law at the exact moment your clients plan to rely on it.
[1] In re Envision Healthcare Corp., Case No. 23-90342, 2023 Bankr. LEXIS 2915, __ B.R. __ (Bankr. S.D. Tex. Dec. 12, 2023).
[2] In re DB Capital Holdings, LLC, Bankr. No. 10-23242, Chapter 11, 2010 Bankr. LEXIS 6567 (B.A.P. 10th Cir. 2010) (unpublished disposition).
[3] Id. at *4-5.
[4] Id. at *1.
[5] Id. at *3-4.
[6] Id. at *1-4.
[7] Id. at *4.
[8] Id. at * 4-5.
[9] Id. at *6.
[10] Id.
[11] Id. at *4-5.
[12] Id. at *5-11.
[13] Id. at *6.
[14] Id. at *6, n. 15.
[15] Id. at *6.
[16] Id. at *6-7
[17] Id.
[18] In re Envision Healthcare Corp., 2023 Bankr. LEXIS 2915, at *7
[19] Id. at *7-8.
[20] Id. at *8.
[21] Id.
[22] Id.
[23] Id.
[24] Although the operating agreement was silent on this issue, that void was filled by the provisions of Section 18-304 of the Del. LLC Act. In other words, while not explicitly stated in the Folsom operating agreement, the right to strip a bankrupt member of its voting and management rights was implied as a matter of law under the default provisions of the Delaware LLC Act.
[25] In re Envision Healthcare Corp., 2023 Bankr. LEXIS 2915, at *8.
[26] Id.
[27] Id. at *8-9.
[28] Id. at *7.
[29] Id. at *14-15.
[30] Id. at *13 (citing 11 U.S.C. § 541(a)(1)).
[31] Id. at * 13.
[32] 11 U.S.C. § 541(c)(1)(B).
[33] In re Envision Healthcare Corp., 2023 Bankr. LEXIS 2915, at *16 (emphasis in original).
[34] Id.
[35] Id. at *15.
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