A Cautionary Tale for Lender Overreaching into Bankruptcy Remoteness

The debtor, Lexington Hospitality Group, LLC (the Debtor), was organized as a Kentucky limited liability company in May 2015. Reflected in the Debtor's operating agreement, Janee Hotel Corporation (Janee) was the sole member and Company Manager, and vested with authority over day-to-day operations. The Debtor's original operating agreement did not contain any provisions expressly addressing authority to file bankruptcy.

In September 2015, the Debtor acquired a hotel located at 5532 Athens Boonesboro Road, Lexington, Kentucky. PCG Credit Partners, LLC (the Lender) provided secured financing. And, in connection with the loan, the Debtor amended and restated its operating agreement.

The Debtor's amended and restated operating agreement dated Sept. 29, 2015 (the Amended Operating Agreement) reflected the admission of 5532 Athens LLC (5532 Athens) as a member of the Debtor. Significantly, the Lender owned and/or controlled 5532 Athens, which held a 30% membership in the Debtor. The interest of 5532 Athens was referred to as an “Equity Kicker” throughout the various documents.

The Amended Operating Agreement provided that 5532 Athens is admitted until the Debtor repaid the loan and the Equity Kicker. The Amended Operating Agreement also restricted dilution of 5532 Athens's membership interest until such repayment.

The Amended Operating Agreement contained a number of restrictions on the Debtor's ability to file bankruptcy. The Amended Operating Agreement provided: “The Company may declare Bankruptcy only so long as the Independent Manager authorizes such action.” Julia McCullough was appointed as the “Independent Manager.”

Similar restrictions were included in Addendum No. 1 to the Amended Operating Agreement (titled “Single Purpose Entity Provisions”). Per Article Three of Addendum No. 1, “In order for the Company to declare Bankruptcy or dissolve and liquidate its assets, the Independent Manager must provide authorization, and then only upon a 75% vote of the Members.” Article Three also limited the Independent Manager's “true independence,” requiring consideration of the interests of creditors and 5532 Athens, and eliminating any fiduciary duty to other members and managers.

In February 2017, the Debtor and the Lender entered into a forbearance regime requiring execution of an Addendum No. 2 to the Amended Operating Agreement, pursuant to which 5532 Athens's equity stake was increased to 50%. The Debtor then defaulted under the Forbearance Agreement and, in the face of enforcement action, filed for Chapter 11 relief. Janee executed the bankruptcy petition and nothing in the corporate resolution indicated that a proper vote of the membership occurred. The Lender moved to dismiss the bankruptcy on the basis of the bankruptcy restrictions in the organizational documents.

The Bankruptcy Court's Decision

The court in Lexington Hospitality Group invalidated the bankruptcy restrictions and therefore denied the Lender's motion to dismiss. The court acknowledged that, while state law governs whether a business entity is authorized to file for bankruptcy, bankruptcy restrictions call into question strong federal public policy favoring fresh starts in bankruptcy. “'It has been said many times and many ways. Prepetition agreements purporting to interfere with a debtors rights under the Bankruptcy Code are not enforceable.'” Id. at 683 (quoting In re Intervention Energy Holdings, LLC, 553 B.R. 258, 263 (Bankr D. Del. 2016)).

The court then went on to note that attempts to contract away the right to file bankruptcy are generally unenforceable. It distinguished cases where the members ostensibly agreed freely among themselves to not file bankruptcy, id. at 683-84 (citing In re Squire Court Partners LP, No. 4:16CV00935JLH, 2017 WL 2901334, at 4 (E.D. Ark. July 7, 2017) (holding it was not proper to ignore the corporate governance documents “when the owners retain for themselves the decision whether to file bankruptcy”); DB Capital Holdings, LLC v. Aspen HH Ventures, LLC (In re DB Capital Holdings, LLC), 463 B.R. 142, at 3 (B.A.P. 10th Cir. 2010) (unpublished) (an agreement forced on members by a creditor solely for its own interest is distinguishable from an agreement among members)), from cases where bankruptcy restrictions were imposed at the behest of a creditor, id. (citing In re Intervention Energy Holdings, LLC, 553 B.R. at 263-64; In re Michigan Beach Pottawattamie Resort, LLC, 547 B.R. 899, 913 (Bankr. N.D. Ill. 2016); In re Bay Club Partners-472, LLC, No. 14-30394-RLD11, 2014 WL 1796688, at 4-5 (Bankr. D. Or. May 6, 2014)). With regard to the former category of cases, in Intervention Energy Holdings:

“A provision in a limited liability company governance document obtained by contract, the sole purpose and effect of which [was] to place into the hands of a single, minority equity holder the ultimate authority to eviscerate the right of that entity to seek federal bankruptcy relief, and the nature and substance of whose primary relationship with the debtor is that of creditor — not equity holder — and which owes no duty to anyone but itself in connection with an LLC's decision to seek federal bankruptcy relief, [was] tantamount to an absolute waiver of that right, and, even if arguably permitted by state law, [was] void as contrary to federal public policy.”

Id. at 684 (quoting In re Intervention Energy Holdings, LLC, 553 B.R. at 265).

Ultimately, the court in Lexington Hospitality Group found that the bankruptcy restrictions in the Debtor's organizational documents, “alone or working in tandem,” violated public policy and were invalid for two principal reasons. Id. at 686. First, the bankruptcy restrictions were imposed via Lender control. Evidencing such control, the court observed that the original operating agreement contained no bankruptcy restrictions and that 5532 Athens (an entity the Lender controlled) received the Equity Kicker as a condition to the loan.

Second, it was clear that the grand purpose of the bankruptcy restrictions was to prohibit the Debtor's ability to file bankruptcy without the Lender's consent. The Independent Manager was not truly independent because she was instructed to consider the interests of creditors and 5532 Athens, abrogating her fiduciary duty. The Amended Operating Agreement also limited the Independent Manager's tenure to repayment of the loan and the Equity Kicker, thus linking the Independent Manager directly to the loan.

The court also found that the Independent Manager was “merely a pretense to suggest that the right to file bankruptcy is not unfairly restricted.” Per Article Three of the Amended Operating Agreement, even if the Independent Manager authorized a bankruptcy filing, a 75% majority vote was needed. Given that 5532 Athens held a 33% interest that could not be diluted (and later increased to 50%), the Lender could always use its control of 5532 Athens to block a bankruptcy filing. And, the Lender's blocking ability was even more substantial in Article Two of Addendum No. 1. This section vested absolute veto power in the Lender irrespective of members' consents. Unlike a member or manager, the Lender had “no restrictions and no fiduciary duties … that might limit self-interested decisions that ignore the best interests of the Company.” Id. at 686 (citing In re Michigan Beach Pottawattamie Resort, LLC, 547 B.R. at 913).

Comment

Lexington Hospitality Group blurs the lines between the two general categories of cases testing the limits of bankruptcy remoteness. The first category is where members agree among themselves to not file bankruptcy. Absent creditor coercion, bankruptcy remoteness likely survives. See, e.g., In re Squire Court Partners LP, 2017 WL 2901334, at 4; DB Capital Holdings, LLC, 463 B.R. 142, at 3. The second category of cases concerns bankruptcy restrictions implemented at the behest of a creditor. In In re Intervention Energy, 553 B.R. at 265-66, the court held that it was against public policy for a creditor to require that a borrower issue the creditor a “golden share” and amend its operating agreement to require unanimous consent to file bankruptcy in order for the creditor to block a bankruptcy filing. In that case, however, the court seemingly focused on creditors' “minority equity holder” position. Id. at 265.

Lexington Hospitality Group answers the question about which category of cases is more appropriate where the Lender holds a meaningful equity stake. The court effectively held the second category was more appropriate and that the extent of the equity did not matter. The focus was on lender control and what the court considered to be overreaching by this particular Lender. Despite the court's “alone or working in tandem” language, it remains to be seen whether bankruptcy remoteness might be upheld if the Lender were not so entangled with the Independent Manager and did not hold absolute veto power.

Going forward, lenders would be wiser to stake reliance in bankruptcy remoteness upon “bad boy” guaranties, or to gamble with a true independent. In Michigan Beach Pottawattamie Resort, 547 B.R. at 913, the court mapped-out the “essential playbook for a successful blocking director structure” as follows: “the director must be subject to normal director fiduciary duties and therefore in some circumstances vote in favor of a bankruptcy filing, even if it is not in the best interests of the creditor that they were chosen by.” The court's warning in In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009), should be heeded: “if Movants believed that an 'independent' manager can serve on a board solely for the purpose of voting 'no' to a bankruptcy filing because of the desires of a secured creditor, they were mistaken.” Enhancements to independence might be considered, such as terms for the independents, super-majority requirements to votes for bankruptcy filings, prior notice of board membership changes, board observer rights, and equity observer rights.

Favorable state law may also protect bankruptcy remote structures. In Lexington Hospitality Group, 577 B.R. at 686-87, although the court was not persuaded that the grant of authority to Janee over day-to-day excluded filing bankruptcy under applicable Kentucky law, a different result obtained in DB Capital Holdings, 463 B.R. 142, at 5. In that case, a requirement in the debtor's operating agreement that the manager “conduct and operate its business as presently conducted,” coupled with an uncommon provision in the Colorado LLC Act requiring the consent of each member to authorize an act not in the ordinary course of business supported bankruptcy remoteness. Id. (citing Colo. Rev. Stat. §7-80-401 (West 2010)).

In sum, Lexington Hospitality Group is a cautionary tale that a seemingly bankruptcy remote structure may not be as it appears.

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Jeffrey S. Greenberg is an attorney in Baker Donelson's Baltimore office where he focuses on the representation of financial institution and other lender clients in financings, restructurings and enforcement matters. He can be reached at [email protected].