Border Control: The Enforceability of Contractual Restraints on Bankruptcy Filings, Part 2

20 Min Read By: Paul R. Hage

IN BRIEF

  • Waiving or contracting away the right to file for relief under the Bankruptcy Code is contrary to public policy.
  • However, a number of courts have held that operating agreement provisions limiting the authority of members or managers of a limited liability company to file a bankruptcy case are enforceable.
  • How have courts dealt with the difficult issue or blocking provisions in favor of creditors set forth in limited liability company operating agreements?

Introduction

As discussed in part one of this two-part article, there is a general premise in bankruptcy law that waiving or contracting away the right to file for relief under the Bankruptcy Code[2] is contrary to public policy. Thus, contractual waivers of such rights are generally deemed invalid. Nevertheless, as the case law has developed over the years, a number of courts have held that operating agreement provisions that set limits on the authority of members or managers of a limited liability company to file a bankruptcy case are enforceable. In recent years, lenders have become more creative in seeking to reduce or eliminate their bankruptcy risk. In this regard, a common approach is to create a bankruptcy-remote limited liability company by obtaining, either directly or through a nominee, a so-called golden share in their borrower. Contemporaneously, the lender insists that its borrower incorporate various blocking provisions into their operating agreement such that it can utilize a bankruptcy approval requirement to effectively preclude a bankruptcy filing. When a bankruptcy is filed notwithstanding the inclusion of such provisions, challenging issues are raised. Part two of this article will discuss how courts have dealt with such issues.

Blocking Provisions in Favor of Creditors Are Unenforceable on Public Policy Grounds

Although the law in this area remains in the early stages of development, the cases discussed below suggest that a blocking provision contained in a limited liability company operating agreement in favor of a lender who also holds an equity interest will likely be deemed invalid as contrary to federal public policy.

In re Bay Club Partners-472, LLC. In In re Bay Club Partners-472,[3] the debtor was formed to renovate and operate an apartment complex in Arizona and borrowed $24 million from the lender to finance such efforts. Years later, after multiple defaults by the debtor, the debtor commenced a chapter 11 bankruptcy case. The petition was signed by the debtor’s manager and was accompanied by a written consent prepared to document authorization of the chapter 11 filing that was signed by three of the debtor’s four members, representing 80 percent of the debtor’s equity. The fourth member opposed the bankruptcy filing.

The operating agreement contained a bankruptcy waiver provision that provided that the debtor “intends to borrow money with which to acquire the Property, and to pledge the Property and related assets as security therefor.”[4] The operating agreement went on to provide that the debtor “shall not institute proceedings to be adjudicated bankrupt or insolvent” until “the indebtedness secured by that pledge is paid in full.”[5] The operating agreement was executed by all of the debtor’s members at the time of the original loan.

The lender and the dissenting member filed motions to dismiss the bankruptcy case. The court began its analysis by acknowledging that much of the parties’ arguments focused on state law. However, the court concluded, disposition of the motions to dismiss was governed by federal law. The court noted: “The Ninth Circuit has been very clear that a debtor’s prepetition waiver of the right to file a bankruptcy case is unenforceable because it is a violation of public policy.”

Acknowledging that the lender had not requested any bankruptcy waiver language in the loan documents, the court observed that: “What the evidence established in this case is more cleverly insidious.”[7] The court found that the lender had requested that the bankruptcy waiver be included with its requests for other restrictive covenants in the operating agreement, and that such provision was included in the operating agreement without any discussion among the members. The court deemed the provision unenforceable, reasoning:

The purpose of the bankruptcy waiver provision to prevent a bankruptcy filing while any amount was owed on the Loan debt is clear from the provision of . . . the Operating Agreement that the restrictive covenants of Article XI would only be effective “[u]ntil such time as the [Loan] indebtedness secured by that pledge is paid in full.” That the members of Bay Club signed the Operating Agreement among themselves rather than acquiescing in the bankruptcy waiver provision in a Loan agreement with [lender] is a distinction without a meaningful difference. The bankruptcy waiver in . . . the Operating Agreement is no less the maneuver of an “astute creditor” to preclude [the debtor] from availing itself of the protections of the Bankruptcy Code prepetition, and it is unenforceable as such, as a matter of public policy.[8]

The court held that the bankruptcy waiver provisions were unenforceable and allowed the case to proceed.

Lake Michigan Beach Pottawattamie Resort, LLC. In In re Lake Michigan Beach Pottawattamie Resort,[9] a lender financed the purchase of a vacation resort. Six months later, the debtor defaulted on the loan. After the lender commenced a mortgage foreclosure action, the parties entered into a forbearance agreement under which the debtor’s operating agreement was modified to make the lender a “special member” with the right to approve or disapprove any “material” action, including the right to file for bankruptcy relief. Notwithstanding its “special member” status, the lender had no rights in profits or losses, distributions, or tax consequences, and expressly would not owe any fiduciary duties to the debtor or the other members.

Thereafter, the debtor filed a chapter 11 petition without the lender’s consent. The lender moved to dismiss the bankruptcy case, arguing among other points, that the bankruptcy was filed without the requisite corporate authority. The Bankruptcy Court for the Northern District of Illinois rejected this argument. The court observed that, in general, absolute prohibitions against filing for bankruptcy are void against public policy,[10] but suggested that restrictions in corporate control documents may be treated differently from those in contracts. Nevertheless, the court determined:

common wisdom dictates that the corporate control documents should not include an absolute prohibition against bankruptcy filing. Even though the blocking director structure described above impairs or in operation denies a bankruptcy right, it adheres to that wisdom. It 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.[11]

The court found that the amendment to the operating agreement was void under Michigan law because the special member expressly owed no fiduciary duties and was not required to consider the debtor’s interests.[12] The court colorfully summarized its view of the law as follows:

The essential playbook for a successful blocking director structure is this: 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 creditors that they were shoes be. [The lender’s] playbook was, unfortunately, missing this page.[13]

Turning to Michigan law, the court found that as a member of a Michigan limited liability company, the special member was required to consider the interests of the debtor.[14] The court found that the blocking provision was void because it allowed the special member to consider only its own interests, in violation of Michigan law. “By excluding the Debtor’s interests from consideration” by the lender when acting as the special member of the debtor, the operating agreement “expressly eliminates the only redeeming factor that permits the blocking director/member construct.”[15] Thus, the court found, the provision was unenforceable both as a matter of Michigan corporate governance law and bankruptcy law.

In re Intervention Energy Holdings. In In re Intervention Energy Holdings, LLC,[16] the debtor was an oil and gas exploration and production company mainly doing business in North Dakota. The debtor, a Delaware limited liability company, entered into an agreement through which the lender agreed to loan up to $200 million. The debtor defaulted on the loan, and the parties entered into a forbearance agreement. In exchange for the lender waiving all defaults, the debtor agreed to give the lender one share in order to make the lender a common member of the limited liability company. The debtor also amended its operating agreement to require unanimous consent of all common members in order to file bankruptcy.

The debtor and certain affiliates ultimately sought chapter 11 protection with the consent of all members except the lender in the Bankruptcy Court for the District of Delaware. The lender filed a motion to dismiss, arguing that the debtor lacked authority to file bankruptcy because it had not consented to the filing. Noting that Delaware state law authorizes members of a limited liability company to eliminate fiduciary duties, the lender argued that a limited liability company that has done so may contract away its rights to file bankruptcy at will.[17] The lender also cited to cases in which courts have upheld consent provisions among members.[18] It warned that if the bankruptcy court declared the agreement void, it would cause confusion concerning the breadth of a limited liability company’s right to contract.[19]

Conversely, the debtor relied upon Lake Michigan Beach to argue that the blocking member could not abrogate its fiduciary duties and “must retain a duty to vote in the best interest of the potential debtor to comport with federal bankruptcy policy.”[20] The debtor also argued that if the provision were enforced, debtor/creditor relationships would dramatically change, and future lenders would demand similar provisions in future transactions.

Declining to address the parties’ state law arguments, the court decided the case on federal public-policy grounds. The court found that the amendment was an absolute waiver of the limited liability company’s right to file for bankruptcy, which was unenforceable as a matter of federal law. The court explained:

It has been said many times and many ways. “[P]repetition agreements purporting to interfere with a debtor’s rights under the Bankruptcy Code are not enforceable.” “If any terms in the Consent Agreement . . . exist that restrict the right of the debtor parties to file bankruptcy, such terms are not enforceable.” “[A]ny attempt by a creditor in a private pre-bankruptcy agreement to opt out of the collective consequences of a debtor’s future bankruptcy filing is generally unenforceable. The Bankruptcy Code pre-empts the private right to contract around its essential provisions.” “[I]t would defeat the purpose of the Code to allow parties to provide by contract that the provisions of the Code should not apply.” “It is a well settled principal that an advance agreement to waive the benefits conferred by the bankruptcy laws is wholly void as against public policy.”[21]

This rule is not new, the court noted while citing various cases that date back to the early 1900s.[22] Nevertheless, “[t]oday’s resourceful attorneys have continued th[e] tradition” of trying to contract around bankruptcy.[23]

The court acknowledged that other courts have upheld provisions in limited liability company agreements requiring unanimous consent or supermajority approval to file for bankruptcy. However, such cases were distinguishable because the Intervention Energy operating agreement was amended pursuant to a forbearance agreement with a lender, as opposed to included by the members when the limited liability company was organized. The court concluded by explaining:

The federal public policy to be guarded here is to assure access to the right of a person, including a business entity, to seek federal bankruptcy relief as authorized by the Constitution and enacted by Congress. It is beyond cavil that a state cannot deny to an individual such a right. I agree with those courts that hold the same applies to a “corporate” or business entity, in this case an LLC.

A provision in a limited liability company governing document obtained by contract, the sole purpose and effect of which is 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, is tantamount to an absolute waiver of that right, and, even if arguably permitted by state law, is void as contrary to federal public policy.[24]

In a footnote, the court distinguished the lender from the lender in Global Ship Systems (discussed in part one of this two-part article). The court noted that the creditor in Global Ship Systems had a 20-percent equity interest, whereas the creditor in Intervention Energy had only one share that was provided as part of a forbearance agreement.[25] The court also referenced, and expressly disagreed with, the conclusion of the DB Capital Holdings’ courtthat contractual waivers of the right to file a bankruptcy case may be enforceable absent coercion by a lender.

In re Lexington Hospitality Group, LLC. In In re Lexington Hospitality Group, LLC,[26] the debtor was a Kentucky limited liability company and owned and operated a hotel. The lender had provided the financing to purchase the hotel. Contemporaneously with the execution of the loan documents, an amended operating agreement was executed admitting 5332 Athens, an entity wholly owned by the lender, as a member of the debtor with a 30-percent membership interest. The amended operating agreement also included several provisions that limited the debtor’s ability to file bankruptcy and required a 75-percent vote of the members. The debtor defaulted on the loan and filed a bankruptcy petition. The lender filed a motion to dismiss the bankruptcy case, arguing that the debtor did not have the corporate authority to file the bankruptcy petition.

The court acknowledged that the authority to file for bankruptcy is governed by state law, but that the validity of the restriction on filing bankruptcy is controlled by federal law. Relying on the cases discussed above, the court held that a contract term imposed by a creditor that prohibits a bankruptcy filing is void as contrary to federal public policy. The same was true where, as here, the so-called independent director was really a nominee of the lender. The court determined:

A requirement that an independent person consent to bankruptcy relief, properly drafted, is not necessarily a concept that offends federal public policy. The appointment of an independent person to help decide the need for a bankruptcy filing may suggest fairness on all sides. The input of a truly independent decision maker avoids the fear and risk that a member of manager will act in its own self-interest. But [the operating agreement] shows that the Independent Manager is not a truly independent decision maker.[27]

The court found that the lender’s complete control over 5532 Athens gave it total control to block any bankruptcy filing. “Unlike a member or manager, [5532 Athens] has no restrictions and no fiduciary duties to [the debtor] that might limit self-interested decisions that ignore the best interests of the [debtor].”[28] In any event, the grant to the lender’s nominee of 30 percent of the equity in the debtor itself gave the lender the ability to block a bankruptcy filing. “Such provisions, alone or working in tandem, serve only one purpose: to frustrate [the debtor’s] ability to file bankruptcy.”[29] As a result, the court found, they were unenforceable. Consequently, the court denied the lender’s motion to dismiss the case.

In re Franchise Services of North America. In In re Franchise Services of North America,[30] the Fifth Circuit Court of Appeals became the first appellate court to weigh in on these issues, holding that federal law does not prevent a bona fide shareholder from exercising its right in the company’s governing documents to prevent the filing of a bankruptcy petition by the company merely because it is also a creditor. The court was careful to limit the scope of its holding to the facts before it, and avoided ruling broadly on the validity of “golden share” or blocking provisions.

An investment bank made an investment of $15 million in the debtor pre-petition. In exchange, the bank received 100 percent of the debtor’s preferred stock. At the same time, the debtor reincorporated in Delaware and amended its certificate of incorporation. As a prerequisite to filing a voluntary bankruptcy petition, the amended certificate required the consent of a majority of each class of the debtor’s common and preferred shareholders.

Following some ill-fated business decisions, the debtor filed for bankruptcy. Fearing that its shareholders might nix the filing, the debtor never put the matter to a vote. The preferred shareholder filed a motion to dismiss the bankruptcy petition as unauthorized. The debtor argued that the shareholder, who was also a sizable creditor, had no right to prevent the filing, relying on the aforementioned cases. The bankruptcy court sided with the shareholder and dismissed the petition.

Given the frequency with which this issue has arisen in chapter 11 cases in recent years, direct appeal to the Fifth Circuit was authorized. Three questions, which broadly asked the appellate court to address the legality of “blocking provisions” or “golden shares,” were certified. Instead of addressing the certified questions, which the Fifth Circuit found would have required it to give an advisory opinion, the court narrowed the issue to the specific facts before it: “when a debtor’s certificate of incorporation requires the consent of a majority of the holders of each class of stock, does the sole preferred shareholder lose its right to vote against (and therefore avert) a voluntary bankruptcy petition if it is also a creditor of the corporation?”[31]

The Fifth Circuit began its analysis by noting that state law determines who has the authority to file a voluntary bankruptcy petition for a company. Where, as here, the petitioners lack authorization under state law, the court noted, the bankruptcy court “has no alternative but to dismiss the petition.” Acknowledging that numerous bankruptcy courts have invalidated, on federal public-policy grounds, agreements whereby a lender extracts an amendment to the organization’s governing documents granting the lender a right to veto a bankruptcy filing, the court held that simply being a creditor does not prevent a bona fide equity holder from exercising its right under a charter to block a bankruptcy filing. Under the facts of the case before it, the court found that the shareholder was a bona fide equity holder. There was no evidence to show that the shareholder’s equity interest was “merely a ruse” to ensure that it would be paid on its claims against the debtor.[33]

Finally, the court rejected the debtor’s argument that the shareholder’s fiduciary obligations as a controlling shareholder prevented it from blocking the debtor from filing for bankruptcy. The court found that the record did not establish that the shareholder was, in fact, a controlling shareholder exercising actual control over the debtor, such that it would owe fiduciary duties under Delaware law. Even if the shareholder were a controlling shareholder, the court concluded, “[t]he proper remedy for a breach of fiduciary duty claim is not to allow a corporation to disregard its charter and declare bankruptcy without shareholder consent.”[34] Rather, the debtor’s remedy was under state law. Accordingly, dismissal of the debtor’s bankruptcy case was affirmed.

Conclusion

All of the cases discussed herein and in part one of this article begin with the general premise that waiving or contracting away the right to file for relief under the Bankruptcy Code is contrary to public policy. Although the law in this area remains in the early stages of development, the cases suggest that a blocking provision contained in a limited liability company operating agreement in favor of a lender (as opposed to a bona fide shareholder) will likewise be deemed invalid. This is particularly true if: (1) the provision was added at the lender’s behest and during a period of financial distress, (2) the provision eliminates any fiduciary duties to the debtor, (3) the “golden share” was acquired for little or no consideration, and/or (4) the “golden share” is a de minimis percentage of the equity of the debtor.

Regarding the fiduciary duty part of the analysis, applicable state law may also be influential because some states (including Delaware) expressly permit members and managers of limited liability companies to eliminate fiduciary duties in their operating agreement.[35] If a debtor is permitted to, and in fact does, expressly eliminate fiduciary duties, then it is harder to argue that a blocking provision in favor of a lender is contrary to public policy. Conversely, no such authorization exists in many states, including Michigan, the law of which governed in Lake Michigan Beach. Thus, lenders seeking to render their borrowers bankruptcy-remote should ensure that the borrowers are formed as a Delaware limited liability company (or another state that permits waiver) and should eliminate fiduciary duties.[36]


[1] Jaffe Raitt Heuer & Weiss, P.C., [email protected].

[2] The Bankruptcy Code is set forth in 11 U.S.C. § 101 et seq. Specific sections of the Bankruptcy Code are identified as “section __.” Similarly, specific sections of the Federal Rules of Bankruptcy Procedure are identified as “Bankruptcy Rule __.”

[3] In re Bay Club Partners-472 LLC, 2014 WL 1796688 (Bankr. D. Ore. May 6, 2014).

[4] Id. at *3.

[5] Id.

[6] Id. at *4 (citing In re Cole, 226 B.R. at 651–54; In re Huang, 275 F.3d at 1177; In re Thorpe Insulation Co., 671 F.3d at 1026; Wank v. Gordon (In re Wank), 505 B.R. 878, 887–88 (9th Cir. BAP 2014)).

[7] Id. at *5.

[8] Id.

[9] In re Lake Mich. Beach Pottawattamie Resort, LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016).

[10] Id. at 912 (citing Klingman v. Levinson, 831 F.2d at 1296; In re Shady Grove Tech Ctr. Ltd. P’ship, 216 B.R. 386, 390 (Bankr. D. Md. 1998)).

[11] Id. (citing In re Trans World Airlines, Inc., 261 B.R. at 114 (“Bankruptcy courts are loathe to enforce any waiver of rights granted under the Bankruptcy Code because such a waiver ‘violates public policy in that it purports to bind the debtor-in-possession to a course of action without regard to the impact on the bankruptcy estate, other parties with a legitimate interest in the process or the debtor-in-possession’s fiduciary duty to the estate.’”)).

[12] Id. at 912–13 (citing In re Gen Growth Props., 409 B.R. at 64; In re Kingston Square Assocs., 214 B.R. 713, 736 (Bankr. S.D.N.Y. 1997); In re Spanish Cay Co. Ltd., 161 B.R. 715, 723 (Bankr. S.D. Fla. 1993)).

[13] Id. at 913.

[14] Id. at 914 (citing MCL § 450.4404(1) which requires a “manager” to discharge managerial duties “in good faith . . . and in a manner the manager reasonably believes to be in the best interest of the limited liability company.”).

[15] Id.

[16] In re Intervention Energy Holdings, LLC, 553 B.R. 258, 262 (Bankr. D. Del. 2016).

[17] Id. at 262 (citing 6 Del. C. § 18-1101(e)).

[18] Id. (citing In re Orchard at Hansen Park, LLC, 347 B.R. 822, 827 (Bankr. N.D. Tex. 2006); In re Avalon Hotel Partners, LLC, 302 B.R. at 827).

[19] Id. at 264.

[20] Id. at 262 (citing Lake Michigan Beach).

[21] Id. at 263 (citing cases).

[22] Id. (citing In re Weitzen, 3 F.Supp. at 698–99; Nat’l Bank of Newport v. Nat’l Herkimer Cnty. Bank, 225 U.S. 178, 184 (1912)).

[23] Id. (citing NHL v. Moyes, 2015 WL 7008213 at *8 (D. Ariz. Nov. 12, 2015) (“If a contractual term denying the debtor parties the right to file bankruptcy is unenforceable, then a contractual term prohibiting the non-debtor party that controls the debtors from causing the debtors to file bankruptcy is equally unenforceable. Parties cannot accomplish through ‘circuity of arrangement’ that which would otherwise violate the Bankruptcy Code.”).

[24] Id. at 265.

[25] Id. at 265 n.25.

[26] In re Lexington Hospitality Group, LLC, 577 B.R. 676 (Bankr. E.D. Ky. 2017).

[27] Id. at 684.

[28] Id. at 685–86.

[29] Id. at 686.

[30] Franchise Services of North America, Inc. v. U.S. Trustee (In re Franchise Services of North America, Inc.), 891 F.3d 198 (5th Cir. 2018).

[31] Id. at 202.

[32] Id. at 206–07 (citing Price v. Gurney, 324 U.S. 100 (1945)).

[33] Id. at 208.

[34] Id. at 214.

[35] See Del. Code Ann. tit. 6, § 18-1101(c).

[36] Perhaps the most surefire way to preclude a borrower from filing bankruptcy is to require that the members of the borrower personally guarantee the borrower’s indebtedness upon a default or bankruptcy filing by the borrower, through a so-called bad boy guarantee. Such guarantees are usually enforced and, for obvious reasons, dramatically decrease the likelihood that a borrower’s members and managers will elect bankruptcy as a remedy. See, e.g., F.D.I.C. v. Prince George Corp., 58 F.3d 1041, 1046 (4th Cir. 1995).

ABOUT THE AUTHOR

MORE FROM THIS AUTHOR

Login or Registration Required

You need to be logged in to complete that action.

Register/Login