To be sure, bankruptcy is not something that new and emerging businesses often think about. But however unpleasant the thought might be, it may become necessary in the course of running a business to get a fresh start. In the second quarter of 2016, for example, businesses with 1-4 employees constituted 38.39% of business bankruptcy filings, while businesses with 5-9 employees and business with 10-19 employees constituted 18.29% and 9.69%, respectively.[1] While big businesses are not immune from the risks of bankruptcy, the numbers seem to suggest that the vast majority of bankruptcy petitions are filed by small businesses, making it all the more necessary for them to plan ahead.
Under federal bankruptcy law, the filing of a bankruptcy petition triggers an “automatic stay,” prohibiting creditors from taking any action (e.g., lawsuits, debt collection, foreclosure, etc.) against the debtor or its property.[2] The purpose of automatic stay is protection of the debtor from its creditors, giving it some breathing room while the bankruptcy court administers the proceeding. Not surprisingly, creditors loathe automatic stay and would usually try to make it difficult for the debtor to file bankruptcy. For example, loan agreements might contain a clause against bankruptcy and, depending on the situation, lenders might even require the borrowing entity’s operating agreement to be amended to that effect.
In re Lake Michigan Beach Pottawattamie Resort LLC involved a limited liability company (“debtor”) that owned a vacation resort in Coloma, Michigan.[3] The property was mortgaged to BCL to secure a $1,336,000 loan and $500,000 line of credit. When the debtor defaulted on its obligations, the parties entered into a forbearance agreement to extend the due date in exchange for amending the debtor’s operating agreement to make BCL a special member. The special member was given the right to vote on bankruptcy by the debtor LLC as it saw fit—without any obligation to consider the LLC’s interests. Subsequently, the debtor failed to meet its payment obligations again, and this time, BCL initiated a foreclosure proceeding against the property. Just a day before the foreclosure sale, however, the debtor filed bankruptcy in an attempt to stop the foreclosure sale.
Not surprisingly, BCL opposed the bankruptcy proceeding. BCL argued, among other things, that the debtor’s bankruptcy filing was not authorized because BCL, a special member of the debtor LLC, did not approve it. The debtor argued, in response, that the provision in its operating agreement requiring BCL’s consent to bankruptcy was void as against public policy because it amounted to a prohibition of its right to bankruptcy relief. The court noted that on one hand, bankruptcy laws were “so seminally important that they were specifically authorized under the Constitution” and, thus, prohibiting business entities from filing bankruptcy petitions was generally considered bad. But on the other hand, bankruptcy law requires that corporate formalities and state corporate law (in this case, Michigan) be satisfied in commencing a bankruptcy case. Here, it was undisputed that the debtor’s operating agreement was amended explicitly to establish BCL as the special member with the power to block a bankruptcy filing. For BCL’s blocking power to be valid, however, the court said the special member would have to have some sort of fiduciary duties, just like other LLC members under Michigan law, to consider the interests of the LLC and not only their own interests. In the case of BCL, the court said, allowing BCL to consider only its own interests invalidated the blocking member consent provision. Accordingly, the court held the blocking member provision was void and declined to dismiss the debtor’s bankruptcy petition.
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[1] American Bankruptcy Institute, Q2 2016 Business Bankruptcy Filings by Number of Employees (July 20, 2016), http://www.abi.org/newsroom/chart-of-the-day/q2-2016-business-bankruptcy-filings-by-number-of-employees.
[2] 11 U.S.C.§ 362.
[3] See generally In re Lake Michigan Beach Pottawattamie Resort LLC, 547 B.R. 899 (N.D. Ill. 2016). Unless otherwise specified, all references to the case are to this citation.