Contributed by Yvanna Custodio
Let’s head for the beach! No, we’re not giving up our day jobs as we prepare for the Memorial Day weekend. Today’s post, however, involves a long-stalled luxury condominium development in Sag Harbor, New York and efforts of the developer and secured lender to restructure in chapter 11 over the objection of an investor. In a recent decision, the United States Bankruptcy Court for the Eastern District of New York upheld the validity of the bankruptcy filing of debtor East End Development, LLC, concluding that provisions of the limited liability company agreement requiring member consent for certain corporate actions did not apply to the filing of a chapter 11 petition and the managing member had authority to commence the bankruptcy without the consent of the dissenting member.
East End’s project, known as 21 West Water Street, sounds like a place busy Manhattanites would enjoy spending relaxing weekends. According to the affidavit filed in support of the debtor’s first day motions, the luxury condominium development includes terraces facing the Sag Harbor waterfront, as well as plans for a penthouse-level saltwater swimming pool. The development, however, has struggled for many years since it was first proposed in 2006. A 2009 lawsuit over zoning issues slowed the development and, by the fall of that year, contractors liened up the property and walked off the job. East End defaulted under its loan obligations and the secured lender commenced a foreclosure action.
When East End filed for chapter 11 in October 2012, the managing member had agreed on a restructuring with the lender to be effected by a bankruptcy sale of the property. Not so fast, said 21 West Water Street Holdings, Inc., the other LLC member, which held 50% of the membership interests. In its motion to dismiss the chapter 11 petition, 21 West argued that the managing member lacked the authority to file the petition without 21 West’s authority. In the alternative, 21 West urged dismissal of the petition as a bad-faith filing pursuant to section 1112(b) of the Bankruptcy Code. In denying the motion to dismiss, the court construed the LLC operating agreement and concluded that the managing member had full authority to file the petition because the bankruptcy filing was not an enumerated event requiring 21 West’s consent. The court also found insufficient evidence warranting dismissal as a result of bad faith.
Because the debtor was a New York limited liability company, the bankruptcy court turned to New York Limited Liability Company Law to determine whether the managing member had authority to file the petition. The court observed that the operating agreement set forth broad powers of the managing member, in contrast to circumstances requiring 21 West’s consent, which were “narrow and specific.” Among those specific actions requiring consent of the non-managing member were actions to “dissolve, wind-up, or liquidate” the debtor. In declining to fill in what 21 West argued were gaps in the operating agreement, and construe it to require consent of the non-managing member for a chapter 11 filing, the court noted that “liquidation” and “dissolution” have precise meanings under applicable state law and held that they do not include chapter 11 bankruptcy.
Linking the argument of the debtor’s lack of authority to file the petition to its bad-faith filing argument, 21 West asserted that the debtor’s reorganization was futile because the petition was not properly authorized and the case was filed to benefit the secured lender and the managing member. (The court did not discuss the latter point in detail, but did mention allegations that, as a result of the filing, the managing member’s interest holders could be released from personal guarantees and the secured lender could be the successful bidder at a subsequent auction.) Noting that the debtor had filed a liquidating plan, the court observed that, pursuant to section 1123(b)(4) of the Bankruptcy Code, liquidating plans, like plans of reorganization, were an appropriate use of the chapter 11 process. Ultimately, the court found no “objective futility” to the filing of the petition and no “subjective bad faith” warranting dismissal. Concluding that the chapter 11 petition was authorized and that 21 West had failed to establish cause to dismiss the case, the court denied the motion to dismiss.
The East End decision highlights the importance of careful drafting in the organizational documents of an entity. Restrictions on an entity’s ability to file bankruptcy, or consent requirements for a filing, may not be enforced if they are not clear and express in the LLC agreement. This is particularly true in situations where the momentum to restart a long-stalled project would be disrupted if the entity had no recourse to chapter 11. For example, in East End, the court looked past the fact that the debtor’s chapter 11 plan would liquidate the company through a bankruptcy sale and found that the LLC agreement did not require the non-managing member’s consent to the chapter 11 filing even though the agreement expressly included “liquidation” as an action requiring consent.