Authority to File Bankruptcy: What Will a Court Consider?

In re Quad-C Funding LLC, 496 B.R. 135 (Bankr. S.D.N.Y. 2013) –

After a multi-member limited liability company filed a chapter 11 bankruptcy petition, one member (Crossroads) moved to dismiss the case on the basis that the filing was not properly authorized since it did not consent.

This challenge was only the latest in a series of battles between the parties.  The fundamental objection raised by the Crossroads was that the debtor’s operating agreement required a super majority vote of 62.5% to approve certain actions (including a bankruptcy filing), which Crossroads contended meant that it had to consent.

Initially Crossroads did have sufficient voting rights to block a super majority vote.  However, circumstances changed.  Although raising equity capital generally required a super majority vote, the debtor was permitted to raise an additional $200,000 through the sale of common units and up to $5 million through the sale of preferred units.  Without notice to Crossroads, the debtor proceeded to raise capital within this exception –resulting in additional member interests sufficient to dilute Crossroads so that it could no longer block a super majority vote.

Under the operating agreement, Crossroads also had a right to dissolve the debtor under certain circumstances.  When the debtor proposed to amend the operating agreement to eliminate the dissolution right, Crossroads responded with an election to dissolve the debtor effective April 17.  However, the amendment was approved without Crossroads’ consent effective April 13.  In response, Crossroads commenced litigation to obtain dissolution and a declaratory judgment that the amendment was invalid.

As characterized by the bankruptcy court, the state court litigation “has been protracted, involved, and extremely expensive; Crossroads alone appears to have accrued more than $1 million in legal fees to date.”  The state court denied a request for a preliminary injunction by Crossroads, but did find that the debtor was required to advance Crossroads’ legal fees under the terms of a servicing agreement.  The debtor appealed, and the fee order was upheld on appeal.

When negotiations with Crossroads failed, a meeting of members was called to consider authorizing a chapter 11 filing.  Crossroads challenged the admission of new members, arguing that they were not “accredited investors” as contemplated by the securities offering memorandum, and claimed that it continued to have the ability to block the super majority vote required to authorize a bankruptcy filing.

Notwithstanding Crossroads’ objections, the bankruptcy filing was approved by 100% of the preferred members and 63.5% of the common unit members (including approval by the new members, but not Crossroads).  So, Crossroads moved to dismiss the bankruptcy petition on the basis that it was not authorized.  Dismissal was opposed by the debtor and a creditor holding a senior subordinated unsecured note in the amount of $7.25 million that constituted at least 80% of the total scheduled unsecured claims.

The court’s description of the resulting circumstances provides some insight on factors that appear to have influenced its decision:

Debtor in its present guise is defunct; this may be the only thing on which the parties to this motion agree.  Crossroads would apparently like to wind it up; it has already spent more than $1 million trying to bring this about in the State Court and appears to be obviously willing to spend several millions more – at least if it can charge the bill to the Debtor.  Debtor, which is and always has been under the control of Levinson, would apparently like to find a way to buy out Crossroads and preserve Debtor as a functioning entity – something we call a reorganization – but it also agrees that the parties must be divorced.  That is something that the Bankruptcy Code can bring about, cheaply and efficiently, with due regard for rights of creditors, who should not have to stand idly by while insiders litigate themselves into penury and destroy whatever business there was.

In ruling on the motion, the court began by noting that the Bankruptcy Code does not establish specific rules regarding the authority to file a petition.  Bankruptcy courts initially look to state law to define what is required.  However, there can be countervailing federal interests that affect state rights.

The court also noted that part of the goal in enacting the Bankruptcy Code was to avoid the costly and lengthy litigation regarding the threshold issue of whether the debtor was allowed to seek bankruptcy engendered by the prior bankruptcy act.  It interpreted Crossroads’ allegation that the new investors were not “accredited investors” as an argument that:

[T]his Court must put the chapter 11 case on hold indefinitely while we attempt to locate each of the new investors, force them to disclose their income and assets and the income and assets of their spouses as of 2010, and doubtless depose them.  According to Crossroads, the Court must then hold an evidentiary hearing to establish whether each of the individuals was an Accredited Investor three years ago.

The court questioned the relevance of the status of the new investors as accredited investors under securities law in the first place.  But regardless, the court declined to accept Crossroads’ invitation to investigate the matter on the basis that it would be “wrong as a matter of federal policy.”

Considering various factors, the court concluded that the record was “adequate to sustain the petition and on that record finds that Crossroads has not sustained its burden to justify the relief it seeks.”  Given this holding, the court noted that it did not need to go on to consider whether the requirement for a super majority vote, which gave a minority a veto over a chapter 11 filing, was valid.

This case seems to go farther afield than usual in its analysis of authority to file.  In reading this decision one gets the sense that the court was offended by the position taken by Crossroads that the bankruptcy case should be dismissed given that (1) it was itself seeking dissolution, and (2) it was pursuing its position at significant expense to the debtor.  The court also appeared to have reservations about giving a minority member the power to veto a bankruptcy petition that everyone else thought was in the best interests of the debtor.  In seeking to persuade a court, it is worth remembering that the underlying context and policy considerations may be a significant factor in the court’s decision.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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