On September 30, 2013, the Bankruptcy Court for the Eastern District of North Carolina provided a succinct reminder of how important it is to carefully draft, and then comply with, the terms of a limited liability company’s operating agreement. In a short decision, the court dismissed the bankruptcy filing of a limited liability company because the LLC’s management failed to comply with the LLC’s operating agreement’s terms in seeking bankruptcy relief. The court held that the bankruptcy filing was not properly authorized by the operating agreement and therefore invalid.
While the Bankruptcy Code identifies which entities are eligible to file a petition for bankruptcy relief, it does not address the steps each entity must take in seeking that relief. Bankruptcy Code section 301 simply provides that an entity eligible for bankruptcy relief (as described in Bankruptcy Code section 109) may commence a bankruptcy case by filing a petition with the bankruptcy court. To determine whether the filing of that petition was properly authorized by the proposed debtor, bankruptcy courts look to the law of the state in which the company was organized.
In the Springfield case, the LLC was the owner and developer of a subdivision in Youngsville, North Carolina. The North Carolina LLC had two members, each of which in turn was separately owned by two individuals who served as managers of the LLC. One of the managers, a Mr. Cully, filed a voluntary petition for relief under chapter 11 of the Bankruptcy Code in July 2013. The other manager, a Mr. Moody, objected to the bankruptcy filing and agued that Mr. Cully lacked authority to file the bankruptcy petition of behalf of the LLC.
The bankruptcy court looked to North Carolina state law, which provides that management of a LLC vests jointly in all members, unless the operating agreement or articles of organization provide otherwise. The LLC’s operating agreement provided that “[t]he business and affairs of the Company shall be managed by its Management, and not by the Members in their roles as members… At any time when there is more than one Manager, the act of the Management shall be the affirmative vote of a majority of the Managers, unless the approval of a greater number of the Managers is otherwise required…”
The bankruptcy court noted that Mr. Cully and Mr. Moody each held a 50% interest in the LLC and, therefore, a majority, as required by the operating agreement, could only be obtained by the consent of both members. Mr. Cully alone did not have authority under the terms of the operating agreement and under state law to file the petition. With that, the bankruptcy court dismissed the LLC’s bankruptcy petition.
North Carolina state law is by no means unique in looking to a LLC’s operating agreement in reviewing the validity of a LLC’s actions. Laws in Delaware and New York, two popular states for professionals creating new LLCs, also call for courts to look to a LLC’s operating agreement to determine the rights of its members. Keeping that in mind, it is important to thoroughly review and consider the implications of the proposed operating agreement for a new LLC. In addition, it is very important for management to review the terms of their company’s formation documents in connection with any material business decisions.