A recent decision from an Oregon bankruptcy court provides a cautionary tale for lenders attempting to “bankruptcy proof” their borrowers. 

The debtor, Bay Club Partners-472, LLC (the “Company”) was a manager managed limited liability company formed under Oregon law to own and operate a large apartment complex. The manager filed a chapter 11 petition for the Company after its secured lender, Legg Mason (“Lender”), issued a notice of default and set off all of the funds in the Company’s bank account.

The Lender filed a motion to dismiss the Company’s chapter 11 case on the grounds that the Company’s operating agreement contained a provision prohibiting the Company from filing a bankruptcy case until such time as the Company’s indebtedness to the Lender was paid in full. The Company’s counsel testified that the Lender had requested inclusion of the foregoing provision in the Company’s operating agreement.

The bankruptcy court characterized the operating agreement’s restriction on filing a bankruptcy case as a waiver by the Company of its right to file bankruptcy. As such, the court held that the provision was unenforceable as a violation of long-standing public policy that waivers of the right to file bankruptcy are void. The court went on to observe that the existence of the waiver in the Company’s operating agreement (to which the Lender was not a party) rather than in the loan agreement between the Lender and the Company was “a distinction without a meaningful difference. The bankruptcy waiver in . . . the Operating Agreement is no less the maneuver of an ‘astute creditor’ to preclude [the Company] from availing itself of the protections of  the Bankruptcy Code prepetition, and it is unenforceable as such, as a matter of public policy.” As a result, the bankruptcy court denied the Lender’s motion to dismiss the Company’s bankruptcy petition.

While a lender cannot use an express prohibition on filing for bankruptcy to make a borrower “bankruptcy proof,” courts have not invalidated less restrictive measures that reduce the likelihood of a borrower filing a bankruptcy petition. For example, no case has invalidated an operating agreement provision or by-law requiring that an independent director join with inside directors in a unanimous decision authorizing a bankruptcy filing for corporation or a limited liability company. Also, a bankruptcy appellate panel has affirmed a bankruptcy court’s order dismissing a manager managed limited liability company’s chapter 11 petition based on language in the debtor’s operating agreement requiring the company’s manager to “conduct and operate the business as presently conducted. The panel held that the foregoing language” deprived the manager of authority to file a chapter 11 petition for the company: “[f]iling a Chapter 11 proceeding with the attendant  . . . statutory duties placed on debtors-in-possession, and thus on their management, essentially makes it impossible to conduct and operate a business as it was being conducted immediately before the filing of the petition” Finally, the Bay Club decision did not address the enforceability of springing guarantees that make a borrower’s owner(s) fully liable for the borrower’s debt if the borrower files for bankruptcy.