Overview
Limited liability companies (LLCs)—curious creatures of state law—often file bankruptcy. Bankruptcy courts have, therefore, developed a dynamic body of law to evaluate the “bankruptcy remoteness” of LLCs, assessing the appropriateness and enforceability of such terms and structures.
On January 6, 2025, Judge David D. Cleary of the United States Bankruptcy Court for the Northern District of Illinois dismissed the bankruptcy petition of 301 W North Avenue, LLC (Debtor), a Delaware LLC, for a lack of proper corporate authority. In hornbook-like fashion, this case provides critical guidance for structuring Delaware LLCs, particularly regarding “bankruptcy remote” provisions, independent managers’ fiduciary duties, and the balance between creditor protections and access to bankruptcy relief. It also emphasizes the need for careful drafting of LLC agreements to navigate these complex dynamics.
Facts
The Debtor owned a mixed-use property encumbered by a $26 million loan. The loan agreement required the LLC to adopt a “bankruptcy remote” structure, which included appointing an independent manager whose unanimous consent, alongside the other board members, was required for material actions, such as filing for bankruptcy.
After defaulting on the loan and facing foreclosure proceedings, the Debtor filed a voluntary bankruptcy petition without obtaining the independent manager’s consent. The lender moved to dismiss the case, arguing the filing was unauthorized. The court dismissed the case, finding that the independent manager had not consented to the filing. (Not only was consent lacking, but the independent manager testified that she was unaware of the case until receiving a subpoena to testify at the motion to dismiss hearing.) The court further upheld that the operating agreement’s fiduciary duty provisions for the independent manager did not violate public policy or restrict the Debtor’s access to bankruptcy relief.
Analysis and Implications for Delaware LLC Law
Governance Provisions and Fiduciary Duties of Independent Managers
The court reaffirmed the enforceability of LLC operating agreements conditioning bankruptcy filings on independent manager approval. Pursuant to 6 Del. C. § 18-402 and § 18-1101, LLCs are afforded significant flexibility in defining management structures and fiduciary duties through operating agreements. However, governance provisions must not contravene public policy, particularly by effectively barring bankruptcy relief.
The LLC agreement, in this case, required the independent manager to weigh the interests of both the LLC and its creditors. The court deemed these fiduciary duties robust enough to avoid being perceived as exclusively protective of the lender. This decision highlights the need to carefully consider the scope of independent managers’ fiduciary obligations when drafting LLC agreements.
Enforceability of Bankruptcy-Remote Provisions
Judge Cleary differentiated between valid governance mechanisms and provisions that improperly restrict bankruptcy access. Mechanisms that mandate balanced evaluations of a debtor’s financial situation and respect public policy are enforceable. Conversely, provisions functioning as de facto bankruptcy waivers are impermissible. The court highlighted, among other cases, In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016), which included an unenforceable “golden share” provision granting veto rights to a creditor. Here, the independent manager provisions did not amount to an outright bankruptcy waiver but were part of a broader governance structure with fiduciary safeguards. Properly drafted provisions that balance creditor protections and debtor autonomy can withstand judicial scrutiny.
Practical Considerations for Lenders and Borrowers
Lenders should ensure independent manager provisions are enforceable by including fiduciary duties that protect an entity and its creditors. Avoid provisions that might appear as granting creditors absolute or too much control over bankruptcy decisions and other material actions, such as dissolutions or mergers.
Borrowers must carefully monitor corporate formalities and governance requirements. Failure to adhere to these requirements can result in a bankruptcy dismissal. Borrowers should also actively involve independent managers in discussions that implicate their duties. This includes establishing clear protocols for due diligence and communication to mitigate risks of noncompliance.
Broader Impact on Bankruptcy Practice
This case underscores increasing judicial scrutiny of governance provisions in bankruptcy-remote entities. While Delaware LLCs benefit from significant contractual flexibility, they remain bound by public policy limits that protect access to bankruptcy relief. This case also highlights the common pitfalls, such as failing to consult independent managers or misunderstanding operating agreements, which can undermine a bankruptcy.
Clients structuring Delaware LLCs or financing transactions should take the following actions to mitigate risks
- Review and Update LLC Agreements: Ensure compliance with Delaware law and evolving bankruptcy jurisprudence.
- Assess Independent Managers’ Roles: Confirm that independent managers’ duties align with fiduciary standards and include debtor and creditor considerations.
- Strengthen Governance Protocols: Implement internal procedures to guarantee adherence to governance requirements, particularly during financial distress.
This case underscores increasing judicial scrutiny of governance provisions in bankruptcy-remote entities. While Delaware LLCs benefit from significant contractual flexibility, they remain bound by public policy limits that protect access to bankruptcy relief.
