Blocking Member Provision in LLC Agreement Designed to Prevent Bankruptcy Filing Unenforceable

A contractual waiver of an entity's right to file for bankruptcy is generally invalid as a matter of public policy. Nonetheless, lenders sometimes attempt to prevent a borrower from seeking bankruptcy protection by conditioning financing on a covenant, bylaw, or corporate charter provision that restricts the power of the borrower's governing body to authorize such a filing. One such restriction—a lender-designated "special member" with the power to block a bankruptcy filing—was recently invalidated by the court in In re Lake Mich. Beach Pottawattamie Resort LLC, 2016 BL 109205 (Bankr. N.D. Ill. Apr. 5, 2016). The court ruled that the "blocking" member provision in the membership agreement of a limited liability company ("LLC") was unenforceable because it did not require the member to comply with his fiduciary obligations under applicable non-bankruptcy law.

Public Policy Against Bankruptcy Waivers

The enforceability of prepetition waivers of the right to seek bankruptcy protection or specific bankruptcy benefits (such as the automatic stay) has been the subject of substantial litigation. Under case law dating back to at least the 1930s, the general rule as a matter of public policy has been that a waiver of the right to file for bankruptcy is unenforceable. See In re Weitzen, 3 F. Supp. 698 (S.D.N.Y. 1933); accord Continental Ins. Co. v. Thorpe Insulation Co. (In re Thorpe Insulation Co.), 671 F.3d 1011 (9th Cir. 2012); Wank v. Gordon (In re Wank), 505 B.R. 878 (B.A.P. 9th Cir. 2014); Nw. Bank & Trust Co. v. Edwards (In re Edwards), 439 B.R. 870 (Bankr. C.D. Ill. 2010); Double v. Cole (In re Cole), 428 B.R. 747 (Bankr. N.D. Ohio 2009); see also In re Madison, 184 B.R. 686 (Bankr. E.D. Pa. 1995) (agreement not to file bankruptcy for certain time period is not binding).

If the law were otherwise, "astute creditors would require their debtors to waive." Bank of China v. Huang (In re Huang), 275 F.3d 1173, 1177 (9th Cir. 2002). By contrast, pre-bankruptcy waivers of the automatic stay are sometimes enforceable. See, e.g., In re BGM Pasadena, LLC, 2016 BL 134299, *3 (Bankr. C.D. Cal. Apr. 27, 2016) ("While it is true that courts have generally treated waivers of the automatic stay as unenforceable when they are contained in prepetition agreements between a lender and a borrower (because the interests of third parties, such as unsecured creditors, for whose benefit the automatic stay exists were not considered at the time the agreement was made), the same cannot be said of waivers that are approved after notice and an opportunity for hearing in the context of an earlier bankruptcy case"); In re DB Capital Holdings, LLC, 454 B.R. 804 (Bankr. D. Colo. 2011); In re Bryan Road, LLC, 382 B.R. 844, 848 (Bankr. S.D. Fla. 2008). But see Ostano Commerzanstalt v. Telewide Systems, Inc., 790 F.2d 206, 207 (2d Cir. 1986) ("Since the purpose of the stay is to protect creditors as well as the debtor, the debtor may not waive the automatic stay").

Special Purpose Entities and Blocking Directors

As a general rule, corporate formalities and applicable state law must be satisfied in commencing a bankruptcy case. See In re NNN 123 N. Wacker, LLC, 510 B.R. 854 (Bankr. N.D. Ill. 2014) (citing Price v. Gurney, 324 U.S. 100 (1945); In re Gen-Air Plumbing & Remodeling, Inc., 208 B.R. 426 (Bankr. N.D. Ill. 1997)); In re Comscape Telecommunications, Inc., 423 B.R. 816 (Bankr. S.D. Ohio 2010). As a result, the unenforceability of contractual provisions that prohibit a bankruptcy filing as a matter of public policy may not close the door on measures designed to preclude a debtor from filing for bankruptcy.

Seizing on this point, lenders, investors, and other parties seeking to prevent or limit the possibility of a bankruptcy filing have attempted to sidestep the public policy invalidating contractual waivers of a debtor's right to file for bankruptcy protection by eroding or eliminating the debtor's authority to file for bankruptcy under its governing organizational documents. See, e.g., DB Capital Holdings, LLC v. Aspen HH Ventures, LLC (In re DB Capital Holdings, LLC), 2010 WL 4925811 (B.A.P. 10th Cir. Dec. 6, 2010); NNN 123 N. Wacker, 510 B.R. at 862; In re Houston Regional Sports Network, LP, 505 B.R. 468 (Bankr. S.D. Tex. 2014); In re Quad-C Funding LLC, 496 B.R. 135 (Bankr. S.D.N.Y. 2013); Green Bridge Capital S.A. v. Ira Shapiro (In re FKF Madison Park Group Owner, LLC), 2011 BL 24531 (Bankr. D. Del. Jan. 31, 2011); In re Global Ship Sys. LLC, 391 B.R. 193 (Bankr. S.D. Ga. 2007); In re Kingston Square Associates, 214 B.R. 713 (Bankr. S.D.N.Y. 1997). These structures have not always been enforced, particularly where the organizational documents include an outright prohibition of any bankruptcy filing. See In re Bay Club Partners-472, LLC, 2014 BL 125871 (Bankr. D. Or. May 6, 2014) (refusing to enforce restrictive covenant in debtor limited liability company's operating agreement, rather than loan agreement, prohibiting bankruptcy filing and stating that covenant "is no less the maneuver of an 'astute creditor' to preclude [Bay Club Partners] from availing itself of the protections of the Bankruptcy Code prepetition, and it is unenforceable as such, as a matter of public policy") (a more detailed discussion of Bay Club Partners can be found in the July/August 2014 issue of the Business Restructuring Review).

Many of these efforts have been directed toward "bankruptcy remote" special purpose entities ("SPEs"). An SPE is an entity created in connection with a financing or securitization transaction structured to ring-fence the SPE's assets from all creditors except secured creditors or investors (e.g., trust certificate holders) that provide financing or capital to the SPE.

The entity is generally designed to be bankruptcy remote to minimize exposure to a voluntary bankruptcy filing by limiting the circumstances under which the SPE's board or managing members can put the entity into bankruptcy. A common way of achieving this goal is the appointment to the SPE's governing body of an "independent" or "blocking" director.

The organizational documents of an SPE typically will provide that a bankruptcy filing and certain other significant actions must be approved unanimously by the board of directors or other governing body. A director nominated by the lender then has the power to prevent a bankruptcy filing by withholding consent. The documents will further provide that actions requiring unanimity may not be taken if that director's seat is vacant and that the documents may not be amended without the consent of all directors.

Exposure to involuntary bankruptcy can be limited by specifically restricting the secured and unsecured debt that an SPE can incur, thereby limiting the pool of qualified petitioning creditors for an involuntary bankruptcy petition. Finally, SPEs are typically structured to reduce the risk that the corporate structures of an SPE and related entities are disregarded (e.g., through veil piercing or substantive consolidation) by requiring the SPE to observe corporate formalities.

Recent court rulings have led to significant questions regarding the efficacy of the SPE model as an effective means of achieving bankruptcy remoteness. For example, in In re Gen. Growth Props., Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009), the court denied a motion by secured lenders to dismiss voluntary chapter 11 filings by several SPE subsidiaries of real estate investment trust General Growth Properties, Inc. ("GGP"). The lenders argued, among other things, that the loan agreements with the SPEs provided that an SPE could not file for bankruptcy without the approval of an independent director nominated by the lenders. The lenders also argued that, because the SPEs had no business need to file for bankruptcy and because GGP exercised its right to replace the independent directors less than 30 days before the bankruptcy filings, the SPE's chapter 11 filings had not been undertaken in good faith.

The bankruptcy court ruled that it was not bad faith to replace the SPEs' independent directors with new independent directors days before the bankruptcy filings because the new directors had expertise in real estate, commercial mortgage-backed securities, and bankruptcy matters. The court determined that, even though the SPEs had strong cash flows, no debt defaults, and bankruptcy remote structures, the chapter 11 filings had not been made in bad faith. The court found that it could consider the interests of the entire group of affiliated debtors as well as each individual debtor in assessing the legitimacy of the chapter 11 filings.

Among the potential flaws in the bankruptcy remote SPE structure brought to light by General Growth was the requirement under applicable Delaware law that independent directors must consider not only the interests of creditors, as mandated in the charter or other organizational documents, but also the interests of shareholders. Thus, an independent director or manager who simply votes to block a bankruptcy filing at the behest of a secured creditor without considering the impact on shareholders could be deemed to have violated its fiduciary duties of care and loyalty.

Dismissal of a Chapter 11 Case: Bad Faith Filing and Lack of Authority

Section 1112(b) of the Bankruptcy Code provides that a chapter 11 case may be dismissed or converted to a chapter 7 liquidation for "cause." Section 1112(b)(4) sets forth a nonexclusive list of grounds that constitute cause, including, among other things, "the absence of a reasonable likelihood of rehabilitation," failure to file or confirm a chapter 11 plan within the time fixed by the Bankruptcy Code or the court, or the inability to effect "substantial consummation of a confirmed plan."

Although "bad faith" is not listed in section 1112(b)(4), courts have consistently found that the absence of good faith in connection with the filing of a chapter 11 case is cause for dismissal or conversion. The good faith filing requirement is designed to ensure that the burdens imposed on creditors are justified by fulfillment of chapter 11's objectives: preserving going concerns and maximizing assets available to satisfy creditors. The basic thrust of the good faith inquiry has traditionally been whether, viewing the totality of the circumstances, the debtor needs chapter 11 relief. See C-TC 9th Ave. P'ship v. Norton Co. (In re C-TC 9th Ave. P'ship), 113 F.3d 1304, 1309–10 (2d Cir. 1997) (dismissal warranted if "there was no reasonable likelihood that the debtor intended to reorganize and no reasonable probability that it would eventually emerge from bankruptcy proceedings"); NMSBPCSLDHB, L.P. v. Integrated Telecom Express, Inc. (In re Integrated Telecom Express, Inc.), 384 F.3d 108, 119–20 (3d Cir. 2007) (test focuses on "whether the petition serves a valid bankruptcy purpose . . . [and] whether the petition is filed merely to obtain a tactical litigation advantage"); Maryland Port Admin. v. Premier Auto. Servs., Inc. (In re Premier Auto. Servs., Inc.), 492 F.3d 274, 279–80 (4th Cir. 2004) ("a lack of good faith in filing a Chapter 11 petition requires a showing of 'objective futility' and 'subjective bad faith' ").

In addition, lack of authority to commence a bankruptcy case, although not specifically enumerated in section 1112(b)(4), also constitutes cause for dismissal. See NNN 123 N. Wacker, LLC, 510 B.R. at 858; In re ComScape Telecommunications, Inc., 423 B.R. 816 (Bankr. S.D. Ohio 2010); In re A-Z Elec., LLC, 350 B.R. 886 (Bankr. D. Idaho 2006). Moreover, a bankruptcy court need not rely on section 1112(b) for authority to dismiss a case if it concludes that the filing was not duly authorized under applicable non-bankruptcy law. In re Southern Elegant Homes, Inc., 2009 BL 123847 (Bankr. E.D.N.C. June 9, 2009); N2N Commerce, 405 B.R. at 41; In re Telluride Income Growth Ltd. P'ship, 311 B.R. 585 (Bankr. D. Colo. 2004).

In Lake Michigan, the court considered the enforceability of a blocking director structure included in the membership agreement of a bankruptcy remote SPE in connection with a lender's motion to dismiss the SPE's chapter 11 case as having been both unauthorized and filed in bad faith.

Lake Michigan

Lake Michigan Beach Pottawattamie Resort LLC ("LM"), a Michigan LLC, owns a vacation resort property in Coloma, Michigan. In 2014, LM granted a first-priority lien on the property in connection with a secured loan extended by BCL Bridge Funding LLC ("BCL") to LM in the amount of approximately $1.8 million.

LM defaulted on the loan in July 2015. As part of a forbearance agreement with BCL, LM executed an amendment to its LLC operating agreement, which established BCL as LM's fifth "special member," with the right to approve or disapprove "material actions," including the commencement of a bankruptcy case. BCL had no interest in LM's profits or losses, nor was it required to make capital contributions.

The amendment provided that, in exercising its rights as a special member, BCL "shall be entitled to consider only such interests and factors as it desires, including its own interests, and shall to the fullest extent permitted by applicable law, have no duty or obligation to give any consideration to any interest of or factors affecting [LM] or the Members." The section of the amendment entitled "Special Member" further stated that "[t]his Section is written for the express benefit of the Lender . . . and shall supersede any conflicting or inconsistent provision of this Agreement."

LM defaulted on its obligations under the forbearance agreement. On November 2, 2015, BCL commenced a foreclosure sale proceeding with respect to the resort property. The foreclosure sale was stayed when LM, which had ceased operating, filed a voluntary chapter 11 petition on December 16, 2015, in the Northern District of Illinois. Four of LM's members authorized the filing; BCL did not. At the time of the filing, the property was valued at significantly more than the amount owed to BCL.

BCL moved to dismiss the chapter 11 case, arguing that, because LM had filed for bankruptcy on the eve of foreclosure and without BCL's approval, the case had been filed in bad faith in addition to being unauthorized.

The Bankruptcy Court's Ruling

The bankruptcy court flatly rejected BCL's argument that LM had filed for chapter 11 in bad faith simply because there was only a single asset around which to reorganize. The court explained, among other things, that the filing of a bankruptcy petition on the eve of foreclosure does not, by itself, establish bad faith. It further noted that "a debtor may, in good faith, use the bankruptcy system to give it a breathing spell to become cash-flow solvent when it is, as the Debtor is in this case, balance sheet solvent."

The court then addressed BCL's argument that LM's chapter 11 filing should be dismissed because it had not been duly authorized. Under Michigan law, the court explained, a simple majority of members is ordinarily required to approve actions on behalf of an LLC, unless the operating agreement provides otherwise. In this case, LM's operating agreement, as amended, provided that BCL's consent was required for a bankruptcy filing.

However, the court emphasized, BCL's contractual right to block a bankruptcy filing was subject to one important caveat:

[C]ommon wisdom dictates that the corporate control documents should not include an absolute prohibition against bankruptcy filing. . . . Even though the blocking director structure . . . 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 [the] purpose of the secured creditor for whom he or she serves.

Consistent with the rulings in General Growth and Kingston Square, the court in Lake Michigan concluded that a blocking "special member" may withhold consent for a bankruptcy filing only if, in doing so, the member complies with its fiduciary duties. As such, the court wrote that "in some circumstances[, blocking members must] 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 concluded, however, that "BCL's playbook was, unfortunately, missing this page."

Under Michigan law, the court explained, members of an LLC have a duty to consider the interests of the entity as well as their individual interests. According to the court, although the amendment to LM's operating agreement did provide a "savings clause" whereby the specified limitations on BCL's duties were allowed "to the fullest extent permitted by applicable law," the prohibition of a bankruptcy filing without BCL's consent "has no application other [than] that which is impermissible under Michigan law." The court accordingly ruled that the provision requiring BCL's consent to a bankruptcy filing was unenforceable under both Michigan corporate and federal bankruptcy law.

Outlook

As noted, the enforceability of bankruptcy waivers or restrictions frequently arises in the context of SPEs that are designed to be bankruptcy remote as a way to encourage investment and limit the risks of both investors and lenders. Lake Michigan indicates that corporate or LLC structures designed to achieve bankruptcy remoteness are not foolproof. Designation by a lender of independent or blocking directors, or granting lenders special member status, in order to minimize the possibility of a bankruptcy filing is still subject to fiduciary obligations that may be violated by blocking such a filing under all circumstances.

The general rule against waiver of the right to file for bankruptcy, as distinguished from waivers by individual debtors of the right to file for bankruptcy or to receive a discharge, has been the subject of considerable debate. Some commentators, for example, have argued that bankruptcy waivers or restrictions should be enforceable for business entities like SPEs, provided that they are solvent. See, e.g., Comment, Bankruptcy-Remote Special Purpose Entities and a Business's Right to Waive Its Ability to File for Bankruptcy, 28 Emory Bankr. Dev. J. 507 (2012). Whether such waivers should be enforceable was one of the many issues considered by the American Bankruptcy Institute's Commission to Study the Reform of Chapter 11, but it was not addressed in the Commission's final report, which was issued on December 8, 2015.