Should You Reconsider Your Bankruptcy Remoteness Strategy?

In In re Intervention Energy Holdings, LLC, Case No. 16-11247 KJC, 2016 WL 3185576 (D. Del. June 3, 2016), EIG, the holder of certain secured notes, moved to dismiss the Chapter 11 filing on the grounds that the Debtor lacked authority to file bankruptcy without its consent. The bankruptcy court held that a provision contained in an LLC operating agreement allowing a single member to negate the right of the entity to file bankruptcy is void and unenforceable as a matter of federal policy. The bankruptcy court noted that the sole purpose and effect of the provision in question was to provide the member with blocking rights and that the primary relationship of the member was that of a creditor, not an equity holder. The court further noted that the provision sought to absolve the member from exercising any fiduciary duty to anyone, except itself ' an outcome that even if arguably permitted by state law, is void and contrary to federal public policy.

By way of background, the Debtor and its wholly owned subsidiary debtor were private non-operated oil and natural gas exploration and production companies. In connection with a default under the note purchase agreement, the parties entered into a forbearance agreement (the Forbearance Agreement) pursuant to which EIG agreed to waive all defaults if the Debtors raised additional equity to pay down a portion of the existing secured notes by a date certain. As a condition to the effectiveness of the Forbearance Agreement, the Debtors were required to fulfill the following conditions precedent:

The Administrative Agent shall have received a fully executed amendment to the limited liability company agreement of the Parent in form and substance satisfactory to the Administrative Agent (i) admitting EIG or its Affiliate as a member of the Parent with one common unit and (ii) amending such limited liability company agreement to require approval of each holder of common units of the Parent prior to any voluntary filing for bankruptcy protection for the Parent of the Company (the “Consent Provision”).

Id. at *2

In its motion to dismiss, EIG argued that an LLC that has abrogated its fiduciary responsibilities to the extent permitted by Delaware law may contract away its right to file bankruptcy at will. EIG emphasized and insisted in its motion to dismiss that its contracted-for protections, including the Consent Provision, indisputably meant to block any voluntary bankruptcy filing was enforceable. EIG argued that it “bought and paid” for its Common Unit (including all rights related thereto) and that the Forbearance Agreement required, as a condition to the effectiveness, that the Debtor both amend its LLC Agreement to institute the unanimous Consent Provision and grant the blocking share, thus making the intent of the parties clear. EIG warned that if the bankruptcy court were to declare the Consent Provision void as contrary to federal public policy, not only would it vitiate the will of state legislatures that LLC members be free to contract, but also that confusion will reign about the breadth of an LLC's right to contract. Id. at *5

The Debtors, on the other hand, argued that if the bankruptcy court permited the enforcement of the Consent Provision, the landscape in debtor-creditor relations would be dramatically altered ' that lenders would henceforth demand such a provision in every loan/forbearance agreement. The Debtors, relying upon the recent case of In re Lake Michigan Beach Pottawatamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016), drew a parallel between the “golden share” given to EIG and a blocking director installed on the board of a special-purpose entity, arguing that abrogating fiduciary duties is exactly what is fatal to EIG's argument ' that the blocking member (or, in this case, holder of the “golden share”) must retain a duty to vote in the best interest of the potential debtor to comport with federal bankruptcy policy. Id.

Lake Michigan Beach

In Lake Michigan, supra, a secured lender moved to dismiss the Debtor's bankruptcy on two grounds. First, the lender alleged that because the Debtor filed its bankruptcy case on the eve of a foreclosure, the case was filed in bad faith and must be dismissed. The lender, as a member of the Debtor, further argued that the bankruptcy filing was unauthorized because it was filed without its approval. The court denied the motion to dismiss and held that the lender failed to show that the Debtor filed the case in bad faith and further concluded that the Debtor was not prohibited from filing the case under its existing corporate control documents.

The Debtor in Lake Michigan owned a Michigan vacation resort consisting of multiple condominium units, a cabin and some undeveloped land (the “Property”). With respect to the Property, the Debtor granted a mortgage and assignment of rents to the lender to secure a loan and line of credit. The Debtor subsequently defaulted on its monetary obligations and executed a forbearance agreement. One of the principal terms of the forbearance agreement was an amendment to the Debtor's operating agreement. The amendment established the lender as a special member with the right to approve or disapprove of any material action by the Debtor, including the commencement of a bankruptcy case.

The lender in its capacity as the special member of the Debtor, however, had no interest in the profits or losses of the Debtor, no right to distributions or tax consequences, and was not required to make capital contributions to the Debtor ' essentially, the lender was kept separate and apart from the Debtor in all ways but for its authority to block the Debtor from petitioning for bankruptcy relief. Further, when exercising its rights, the lender was not obligated to consider any interests or desires other than its own and had no duty or obligation to give any consideration to any interest or factors affecting the Debtor or its members. Id. at 904.

Subsequently, the Debtor again failed to fulfill its monetary obligations. This time, the lender filed a foreclosure complaint against the Debtor. One day prior to the scheduled non-judicial foreclosure sale, the Debtor filed a Chapter 11 petition, with the consent of all of the members of the Debtor except the lender. The lender moved to dismiss the petition as a bad faith litigation tactic. The bankruptcy court rejected this argument, finding the lender failed to carry its burden by establishing one or more of the applicable factors set forth in In re Tekena USA, LLC, 419 B.R. 341 (Bankr. N.D. Ill. 2009), a case frequently cited with respect to bad faith dismissal motions.

The court rejected the lender's second argument that the bankruptcy filing was unauthorized because the lender as a special member of the Debtor did not consent to the bankruptcy filing. The court relied principally on Michigan corporate governance law to determine whether the filing was a valid corporate action. The court noted that the Debtor was a limited liability company created in Michigan. Therefore, the court must apply the state's corporate governance law in determining whether the filing was a valid corporate action. See In re Gen-Air Plumbing & Remodeling, Inc., 208 B.R. 426, 430 (Bankr. N.D. Ill. 1997) (Squires, J.) (“The authority to file a bankruptcy petition on behalf of a corporation must derive from state corporate governance law.”).

In Michigan, “[u]nless the vote of a greater percentage of the voting interest of members is required by this act, the articles of organization, or an operating agreement, a vote of the majority in interest of the members entitled to vote is required to approve any matter submitted for a vote of the members.” Mich. Comp Law. Ann ' 450.4502(8). Thus, the operating agreement can require more than a majority vote. Id. at 910.

The court noted that: 1) the Debtor's amended operating agreement required a majority of the sharing ratios of the members for consent; and that 2) Michigan allows for operating agreements to override the default majority of interests requirement set forth in section 450.4502(8). Thus, the provision requiring the lender to consent would result in the Debtor's bankruptcy petition being invalid without the consent of lender. The court therefore recognized that that it had to determine the validity of the prohibitions in the amended operating agreement in order to determine whether the petition was authorized under the Debtor's operating agreement and Michigan law and, ultimately, bankruptcy law.

The court initially noted that the lender's position was based on the commercial practice of using “blocking directors.” The bankruptcy court stated that a blocking director holds together a bankruptcy remote special purpose entity because the secured creditor may withhold its vote and thus block a voluntary bankruptcy petition.

The bankruptcy court further noted that the reason to use a blocking director with fiduciary obligations was to temper the prohibition ' since an absolute prohibition against filing for bankruptcy would likely be deemed void as against public policy. The court stated a blocking director provision “has built into it a saving grace: the blocking director must always adhere to his or her general fiduciary duties to the debtor in fulfilling the role. That means that, at least theoretically, there will be situations where the blocking director will vote in favor of a bankruptcy filing, even if in so doing he or she acts contrary to purpose of the secured creditor for whom he or she serves.” Id. at 912

The court concluded that “[u]nder Michigan law, members of a limited liability company have a duty to consider the interests of the entity and not only their own interests. And, while the amendment to the operating agreement limited the duties of the lender “to the fullest extent permitted by applicable law,” this savings clause might cure the invalidity of the prohibition, but only by rendering it meaningless.” Id. at 914.

Takeaways

Both of these cases are examples of a trend of court rulings holding that provisions that prohibit an entity from filing bankruptcy are void and unenforceable. Here, the courts reached this outcome in one case by applying applicable state law, and in the other case as a matter of federal policy. Interestingly, the bankruptcy court in Intervention Energy reluctantly declined in light of its disposition of the federal public policy issue to accept the parties' invitation to decide what may well be a question of first impression of Delaware state law (i.e., determining the scope of LLC members' freedom to contract under applicable state law provisions) when an alternate ground for decision was present. This trend certainly will impact opinion letter practice with respect to structured finance transactions since these cases further clarify the limitations that exist regarding certain bankruptcy remoteness techniques used in such transactions.

It remains to be seen what other impacts these decisions may have in connection with structured finance and asset securitization transactions. Arguably, if the risk of bankruptcy filings is perceived to be greater because lenders cannot prevent or restrict their borrower from filing bankruptcy, then the pricing of such transactions arguably would seem to increase as well. While the degree of change in pricing cannot be predicted, it seems that any change could adversely affect the ability of marginal borrowers to obtain financing.

One possible option for lenders and borrowers to consider is to carefully define the nature and scope of fiduciary duties that must be satisfied in loan and corporate control documents, thereby allowing the lender the ability to at least frame issues and argue that it only need comply with such defined duties. Of course, defining such duties would be a challenge, but given the current state of the law, such creative thinking may be worthwhile exercise.

Robert W. Dremluk, a member of this newsletter's Board of Editors, is a partner in the New York office of Culhane Meadows PLLC. He may be reached at [email protected].