Peter C. Blain on Bankruptcy Remote Special Purpose Entities Are Not Necessarily Bankruptcy Proof 2016 Emerging Issues 7477 Click here for more Emerging Issues Analyses related to this Area of Law. In In re Lake Michigan Beach Pottawattamie Resort LLC., 1 Bankruptcy Judge Timothy A. Barnes of the Northern District of Illinois and in In re Intervention Holdings, LLC, Bankruptcy Judge Kevin J. Carey of the District of Delaware both addressed an issue that is crucial to many business transactions: To what extent are entities protected against a bankruptcy filing by restrictive provisions placed in the entities organizational documents? The restrictions often include the creation of a special purpose entity ( SPE ) which holds collateral, the appointment of an independent director of the SPE by the lender, and the requirement that all directors unanimously consent before the SPE can file a voluntary petition under the United States Bankruptcy Code. 2 This organizational structure is designed to ring fence the assets of the SPE from the claims of creditors other than the lender and is often a condition to the lender s willingness to make the loan. Although both cases dealt with restrictions arising in connection with a loan workout rather than a structure created in connection with the origination of the loan, the principles discussed therein are applicable to all SPEs. The Facts of LAKE MICHIGAN BEACH POTTAWATTAMIE RESORT In January 2015, BCL-Bridge Funding LLC ( BCL ) extended a $1.3 million term loan and a $500,000 line of credit secured by a mortgage on Lake Michigan Beach s vacation resort in Coloma, Michigan. The debtor defaulted in July 2015 and, in connection with a forbearance agreement, BCL required an amendment to the debtor s Operating Agreement which provided for the appointment of a Special Member who had the right to approve or disapprove any Material Actions taken by the debtor. Material Actions were defined to include the filing of a petition in bankruptcy. The Special Member had no interest in profits or losses of the debtor, no right to distributions and was not required to make capital contributions. Significantly, the amendment provided that, in exercising its rights, BCL was not obligated to consider any interests other than its own, and had no duty or obligation to give any consideration to any interest of or factors affecting the Company or the Members. 3 When the debtor failed to pay the obligations owed to BCL by the October 21, 2015 deadline specified in the forbearance agreement, BCL commenced a foreclosure action. The day before BCL was scheduled to conduct a non-judicial foreclosure sale under Michigan law, the debtor filed a petition for relief under Chapter 11 of the Code based upon the consent of only the non-bcl Members. BCL moved to dismiss the petition as being filed in bad faith because it was filed on the 1 In re Lake Mich. Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016). 2 11 U.S.C. 101-1532 (hereinafter the Code ). 3 Id. at 904.
eve of the foreclosure sale and because it was invalid as it lacked the consent of all of the members, including BCL as Special Member, as required by the Operating Agreement. The Claim That The Petition Was Filed In Bad Faith Regarding the claim that the petition was filed in bad faith and therefore should be dismissed pursuant to Code Section 1112(b), Judge Barnes applied the 14 factors enumerated in In re Tekena USA, LLC, 4 decided by the bankruptcy court in the Northern District of Illinois in 2009. Judge Barnes found that BCL distorted some of the facts to attempt to fit within Tekena, and also found that other factors were simply not applicable. Based upon Tekena, the court concluded that the petition was not filed in bad faith. 5 The Validity of the Bankruptcy Filing The court then turned to the issue of whether the petition was not validly filed because of the lack of consent of the Special Member. Because the debtor was formed in Michigan, the court concluded that Michigan corporate governance law must be applied to determine whether the filing constituted a valid corporate action. 6 The court also observed that under the terms of the original Operating Agreement and the amendments preceding the forbearance agreement imposed Third Amendment, the company was authorized to act pursuant to consent of a majority of the Sharing Ratios of the members (based upon capital interests in the company). The court noted that the bankruptcy would have been authorized prior to the Third Amendment. However, as BCL intended, the Third Amendment required that 100 percent consent was required for certain actions, including the filing of a voluntary bankruptcy petition. The court also noted that Michigan law permits provisions of the Operating Agreement to override the statutory default voting provisions of a majority of interests voting being required for valid entity action. Therefore, the validity of the Third Amendment under bankruptcy and Michigan law was the linchpin to whether 100 percent member consent was necessary for a properly filed bankruptcy petition. 7 4 In re Tekena USA, LLC, 419 B.R. 341, 346 (Bankr. N.D. Ill. 2009). The factors are: 1. The debtor has few or no unsecured creditors. 2. There has been a previous bankruptcy petition filed by the debtor or a related entity. 3. The pre-petition conduct of the debtor has been improper. 4. The petition effectively allows the debtor to evade court orders. 5. There are few debts to nonmoving creditors. 6. The petition was filed on the eve of foreclosure. 7. The foreclosed property is the sole or major asset of the debtor. 8. The debtor has no on-going business or employees. 9. There is no possibility of reorganization. 10. The debtor s income is not sufficient to operate. 11. There is no pressure from nonmoving creditors. 12. Reorganization essentially involves the resolution of a two-party dispute. 13. A corporate debtor was formed and received title to its major asset immediately before the petition. 14. The debtor filed solely to create the automatic stay. 5 In re Lake Mich. Beach Pottawattamie Resort, LLC, 547 B.R. at 909. 6 Id. 7 Id. at 911.
The Use of Blocking Directors Turning to the Third Amendment, the court noted that the use of blocking directors in an entity s organization is a common device to prevent a borrower from filing a voluntary bankruptcy petition absent the consent of the lender. Utilizing SPEs and restrictions in organizational documents to prevent unwanted bankruptcy filings is necessary, said the court, because outright contractual prohibitions on filings would likely be deemed void as against public policy, 8 citing Citizens United. 9 Also at play in the analysis is the bankruptcy law precept that corporate formalities and state corporate law must be satisfied in commencing a bankruptcy case. 10 Reconciling these two concepts, the court concluded that the policy against contracting away bankruptcy benefits is not necessarily controlling when what defeats the rights in question is a corporate control document instead of a contract. 11 Fiduciary Duties Apply However, said the court, the blocking powers imbedded in organizational documents must be subject to the strictures of an independent director s or manager s fiduciary duties. Application of those duties may compel an independent director or manager appointed by a secured creditor to authorize a filing, even if that action is contrary to the secured creditor s interests. The court cited the General Growth Properties 12 Chapter 11 cases, where that court, stated 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 the secured creditor, they are mistaken. 13 Building upon General Growth Properties, Judge Barnes said: 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 creditor they were chosen by. BCL s playbook was, unfortunately, missing this page. 14 Because the Third Amendment directed the Special Member to consider only its own interests and not those of the company or the other members, it ran afoul of Michigan s Limited Liability Company Act, which requires a manager to discharge his duties in a manner he believes to be in the best interests of the limited liability company. Consequently, the court concluded that the petition was properly filed because the Third Amendment violated both Michigan corporate governance and bankruptcy law, and therefore was void. 15 8 Id. 9 Citizens United v. Fed. Election Comm n, 558 U.S. 310 (2010) (holding that corporate entities have been held to have, in certain instances, rights akin to those of natural persons). 10 In re Lake Mich. Pottawattamie Resort LLC, 547 B.R. at 912. 11 Id. 12 In re Gen. Growth Props., Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009). 13 Id. at 64. 14 In re Lake Mich. Beach Pottawattamie Resort, LLC, 547 B.R. at 913. 15 Id. at 914..
AN EVEN MORE RESTRICTIVE CASE In a case with very similar facts decided subsequent to Lake Michigan Beach Pottawattamie Resort, the Bankruptcy Court in the District of Delaware appears to virtually foreclose the use by creditors of blocking directors as a device to preclude a bankruptcy filing in In re Intervention Energy Holdings, LLC. 16 In that case, on December 28, 2015, two Delaware limited liability companies entered into a forbearance agreement with their lender, EIG Energy Fund XV-A, L.P. ("EIG"), which provided for the issuance by each LLC of a single common unit to EIG. The forbearance agreement also required the Restated Limited Liability Company Agreements to be amended to require unanimous consent of the unit holders to authorize a bankruptcy filing. Following a default, the debtors filed Chapter 11 petitions on May 20, 2016. On May 26, 2016, EIG filed a motion to dismiss asserting that the filings were not properly authorized. THE USE OF BLOCKING DIRECTORS IS VOID AS AGAINST FEDERAL PUBLIC POLICY Judge Carey began his analysis by noting that absent the amendment to the Limited Liability Company Agreements, the filings would have been authorized. However, the Bankruptcy Code, he observed, pre-empts the private right to contact around its provisions. 17 The court rejected EIG's argument that finding blocking provisions unenforceable would vitiate the will of state legislatures. Instead, the court concluded that the federal public policy to insure access to right of a person, including a business entity, to seek federal bankruptcy protection protects a right authorized by the Constitution and enacted by Congress. "It is beyond cavil," said the court, "that a state cannot deny to an individual such a right." 18 Denying EIG's motion to dismiss, the court held: Conclusion A provision in a limited liability company governance document obtained by contract, the sole purpose and effect of which is to place in 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 a 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. 19 Lake Michigan Beach Pottawattamie Resort confirms that, while contractual prohibitions against seeking relief under the Code are likely void as against public policy, the insertion of restrictive provisions in entity organizational documents empowering a director appointed by the secured creditor to potentially block a filing will be respected, so long as the special director acts in 16 In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016). 17 Id. at 263; (citing In re Pease, 195 B.R. 431 (Bankr. D. Neb. 1996)). 18 Id. at *265. 19 Id.
accordance with his fiduciary duties to act in the best interests of the entity. While the court makes clear that restrictive provisions which purport to override the requirement that a director fulfill his fiduciary duties will be void and unenforceable, it does not provide much guidance about the circumstances under which a special director must consent to a filing to fulfill those duties. Intervention Energy Holdings goes much further. The case suggests that even if the blocking director acts in accordance with his or her fiduciary duties as required by Lake Michigan Beach Pottawattamie Resort, blocking director provisions inserted in the debtor's organizational documents at the instance of its lender are void against public policy and per se unenforceable. These cases stand as a stark reminder that bankruptcy remote is clearly not bankruptcy proof. Click here for more Emerging Issues Analyses related to this Area of Law. About the Author. Peter C. Blain is a shareholder at Reinhart Boerner Van Deuren s.c. and chair of the firm s Business Reorganization Practice. Mr. Blain represents diverse parties in complex distress transactions both in and outside of bankruptcy proceedings, including lenders, debtors, trustees, committees, and other creditors. He has significant expertise in the purchase and sale of troubled businesses and has written extensively on distress mergers and acquisitions in bankruptcy and state court receiverships. In addition to numerous publications and recognition, Mr. Blain was requested by the American Chamber of Commerce and the U.S. Ambassador to the Czech Republic to lead a team to Prague where he addressed Czech judges and lawyers on the reorganization proceedings in light of the Czech bankruptcy statute. He received his J.D. from the Georgetown University Law Center and his B.S., cum laude, from Wisconsin State University-Stevens Point. He may be reached at pblain@reinhartlaw.com. Emerging Issues Analysis is the title of this LexisNexis publication. All information provided in this publication is provided for educational purposes. For legal advice applicable to the facts of your particular situation, you should obtain the services of a qualified attorney licensed to practice law in your state.