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Default Provision Divesting LLC Management Authority Not Self-Executing

Case: Crossover Financial I, LLC, Case No. 11-24257 SBB (Bankr.D.Colo. 2012).

Discussion:  Order Denying Second Motion to Dismiss Chapter 11 Case for lack of Authority to File.  This Matter came before the Court for an evidentiary hearing on May 12, 2012.
The central issue before the Court is whether the sole member and manager of an LLC lacked the statutory and contractual authority to file a Chapter 11 case, placing the LLC into bankruptcy, where creditors contended the sole member/manager (“Mr. Yellen”) acted without the requisite contractual authority pursuant to the Debtor’s Operating Agreement and the Security Agreement held by the secured creditors (collectively the “DeCelles Creditors and Mr. Reineke”).
The DeCelles Creditors and Mr. Reineke asserted that the terms of the Security Agreement for the pledge of a pro rata share of the limited liability company membership interest as security for promissory notes issued in connection with the Debtor’s Private Placement Memorandum divested control of the Debtor’s management from Mr. Yellen.  The DeCelles Creditors’ argument was that the security interest is self-executing.  Thus, upon a default of any respective promissory note, the control of Debtor’s management from its sole member/manager, Mr. Yellen, is divested.  As asserted by counsel for the DeCelles Creditors, the default automatically vested the Debtor’s voting rights in the secured creditors.

The DeCelles Creditors’ argument focused on language found in the Security Agreement:

“At any times after the occurrence of default, the Secured Party also may vote any or all of the Pledged Interest (whether or not transferred) and give all consents, waivers and ratifications, if any, in respect thereof and otherwise act with respect thereto as though they were the outright owners thereof.”

The DeCelles creditors argued that the language causes the agreement to be self-executing as to voting rights.  That is, a default in the promissory notes, standing alone without any other action, notice, or demand, prevented Debtor’s manager, Mr. Yellen, from exercising any voting rights in the Debtor, but particularly, the authorization to file the voluntary petition for bankruptcy relief.

The Court ruled against the Decelles Creditors and Mr. Reineke, relying on the holding of In re Lake County Grapevine Nursery Operations,441 B.R. 653 (Bankr.N.D. Cal. 2010), an analogous case, and colo. rev.stat. §7-80-702(1), which governs limited liability companies in Colorado.  The Court held that Colorado law requires a secured creditor to enforce the security agreement and become admitted as a member before voting rights associated with membership interests pledged as collateral can be exercised.  “Thus, neither the pledging of the membership rights as security nor the declaration of a breach by the secured party is sufficient to divest the pledging member of the right to vote.  To hold otherwise would permit someone who is not a member or manager to control a limited liability company.” (citing Lake County Grapevine Nursery, 441 B.R. at 655).  Thus, it was Ordered that the DeCelles Creditors’ Second Motion to Dismiss and the Joinder thereto filed by Mr. Reineke, were denied.

Key Quotation: “Colorado law (C.R.S. §7-80-702(1)) requires a secured creditor to enforce the security agreement and become admitted as a member before voting rights associated with membership interests pledged as collateral can be exercised.  Thus, neither the pledging of the membership rights as security nor the declaration of a breach by the secured party is sufficient to divest the pledging member of the right to vote.  To hold otherwise would permit someone who is not a member or manager to control a limited liability company.”

– Regina Ries