Consent/Authority to File Bankruptcy: Creditor’s “Blocking Provision” Unenforceable without Equity Interest in LLC

March 13, 2023

     Holding a pledge of the owner’s interest in a limited liability corporation, coupled with an agreement not to file bankruptcy without the lender’s approval, may not prevent the owner from acting in the capacity of the LLC’s manager to file a chapter 7 petition without the lender’s consent, for reasons explained in a March 7 opinion by Bankruptcy Judge Robert L. Jones of Lubbock, Texas.

     An LLC borrowed $4 million from a lender and pledged the LLC’s assets as collateral. An individual was the sole member, sole owner and sole manager of the LLC. He pledged his ownership interest as additional collateral for the loan.

     In addition, the loan agreement purported to bar the LLC from filing bankruptcy without the lender’s consent. In compliance with the loan agreement, the LLC amended its organizational documents to bar a bankruptcy filing without the lender’s consent.

     The LLC defaulted on the loan. According to the lender, the owner/manager lost his voting rights automatically on default. Undeterred, the owner adopted a resolution for the LLC in his capacity as the sole manager and immediately filed a chapter 7 petition for the LLC.

     The lender filed a motion asking Judge Jones to dismiss the petition, asserting the manager’s lack of authority to file. Alternatively, the lender wanted Judge Jones to convert the case to a chapter 11 reorganization under Subchapter V.

     The lender lost across the board.

Dismissal for Lack of Authority

Judges Jones began the analysis by reciting black letter law that corporations “can file voluntary bankruptcy petitions only if the agents acting on their behalf have the proper authority,” and that a case filed by an agent who lacks authority “must be dismissed.”

The lender contended that the owner/manager lost his right to vote automatically when the LLC defaulted on the loan. However, the lender failed to differentiate between the individual’s rights as an owner and as the sole manager.

The owner did not issue the filing resolution in his capacity as the owner. Rather, he issued the resolution as the sole manager. The loan agreement may have divested the owner of his rights to vote as owner, but it did not terminate the owner’s rights as the sole manager.

Indeed, the LLC’s organizational documents only gave owners the right to elect managers and other matters brought to them by the manager. The owners lacked any power themselves to bind or act on behalf of the LLC.

Judge Jones held that the owner/manager “did not use his voting rights as a member to authorize the filing of the bankruptcy petition, so even if his member voting rights were immediately divested, his authority as sole manager was unaffected.”

Judge Jones denied the motion to dismiss because the “board resolution thereby effectively authorized [the LLC] to file its petition.”

The Blocking Position

As required by the loan agreement, the LLC had amended its organizational documents by requiring the lender’s approval before filing bankruptcy. The lender thus argued that the filing was a nullity given the lack of lender approval.

Judge Jones characterized the agreement as a form of a so-called blocking provision. Citing a Collier treatise, he said that a blocking provision imposed by creditors is unenforceable, but that a blocking provision is enforceable if it’s in favor of equity holders.

Although the Fifth Circuit has not ruled, Judge Jones cited several courts, including the Ninth Circuit, for the principle that courts “have found blocking provisions are void on public policy grounds when a creditor, without an ownership interest, retains the ability to block the filing of a petition.”

In the case before him, the lender had not foreclosed its lien on the ownership interest to become an owner in its own right.

Judge Jones held that the blocking provision did not divest the owner of his authority as the sole manager to adopt the resolution and to file the petition, because there was “no precedent for upholding a blocking provision when the blocking creditor holds no ownership interest in the debtor.”

Conversion to Subchapter V

Alternatively, the lender wanted Judge Jones to convert the chapter 7 case to Subchapter V.

Citing the Collier treatise, Judge Jones said that proceeding in Subchapter V is voluntary and that an election to proceed under Subchapter V may only be made by a small business debtor as defined in Section 1182(1). Likewise, he found no Bankruptcy Rule permitting conversion from chapter 7 to Subchapter V without the debtor’s consent.

Judge Jones denied the alternative motion for lack of authority “to convert a case to subchapter V of chapter 11 or to direct the debtor to elect subchapter V.”

In re Robertson Cartridge Co. LLC, 22-20192 (Bankr. N.D. Tex. March 7, 2023).

Leave a Comment

Your email address will not be published. Required fields are marked *