Another Bankruptcy Court Joins the Debate on the Validity of Bankruptcy Blocking Restrictions

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As a matter of federal public policy or applicable state law, courts disagree on whether clauses in a borrower’s organizational documents designed to prevent the borrower from filing for bankruptcy are enforceable. In recent years, a few of court judgements have addressed this topic, with varying results. In re 3P Hightstown, LLC, 631 B.R. 205, the United States Bankruptcy Court for the District of New Jersey weighed in on this contentious topic (Bankr. D.N.J. 2021). Because the LLC agreement prohibited Alabama bankruptcy laws filing without the assent of a holder of preferred membership interests whose capital contributions had not been reimbursed, the court dismissed a chapter 11 lawsuit filed by a Alabama limited liability company (“LLC”). According to the court, the bankruptcy blocking clause was not defective as a matter of public policy since the holder of the preferred membership interests, which held a noncontrolling position, had no fiduciary duties under Alabama law and the stated terms of the LLC agreement.

Lenders’ Risk Management of Bankruptcy

When it comes to borrowers who have the potential to become financially distressed, astute lenders are always looking for strategies to reduce risk, safeguard remedies, and maximize recoveries in connection with a loan. Some of these efforts have been aimed at reducing the likelihood of a borrower filing bankruptcy by making the borrower “bankruptcy remote,” such as by implementing a “blocking director” organizational structure or issuing “golden shares” that give the holder the right to preempt a bankruptcy filing, as the term is used in the bankruptcy context. These procedures may or may not be enforceable depending on the jurisdiction and the specific circumstances, including the provisions of the applicable documents.

In most cases, corporate procedures and applicable state law must be met before a bankruptcy case may be filed. See In re NNN 123 N. Wacker, LLC, 510 B.R. 854 (Bankr. N.D. Illinois 2014) (quoting Price v. Gurney, 324 US 100 (1945)); In re Comscape Telecommunications, Inc., 423 B.R. 816 (Bankr. S.D. Ohio 2010); In re Gen-Air Plumbing & Remodeling, Inc., 208 B.R. 426 (Bankr. S.D. Ohio (Bankr. N.D. Ill. 1997). As a result, while contractual terms against bankruptcy filing may be invalid due to public policy, alternative steps to prevent a debtor from filing bankruptcy may be viable.

Bankruptcy Protection

Lenders, investors, and other interested parties have tried to get around the public policy that invalidates contractual waivers of a debtor’s right to petition for bankruptcy protection by degrading or removing the debtor’s authority to file for bankruptcy under its governing organizational documents. See, for example, In re DB Capital Holdings, LLC, 2010 WL 4925811 (Bankr. 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. (Bankr. S.D.N.Y. 1997).

These kinds of prohibitions haven’t always been followed, especially when the organizational documents expressly forbid any bankruptcy petition. See In re Lexington Hospitality Group, 577 B.R. 676 (Bankr. E.D. Ky. 2017) (where an LLC debtor’s operating agreement required a lender representative to be a 50% member of the debtor until the loan was repaid and included various restrictions on the debtor’s ability to file for bankruptcy while the loan was outstanding, the bankruptcy filing restrictions acted as an absolute bar to a bankruptcy filing, which is void as against public policy); In re Bay Club Part II (Bankr. D. Or. May 6, 2014) (refusing to enforce a bankruptcy filing prohibition in a debtor LLC’s operating agreement, stating that the covenant “is no less the maneuver of a ‘astute creditor’ to prevent [the LLC] from availing itself of the protections of the Bankruptcy Code prepetition, and it is unenforceable as such, as a matter of public policy”)

Bankruptcy Remote

Many of these attempts have been focused on special purpose entities (also known as special purpose vehicles) that are “bankruptcy remote” (“SPEs”). An SPE is a legal entity created as part of a financing or securitization transaction to protect the SPE’s assets from creditors other than secured creditors or investors (e.g., trust certificate holders) who provide the SPE with funding or capital.

In re Gen. Growth Props., Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009), for example, the court granted secured lenders’ petition to dismiss voluntary chapter 11 filings by numerous SPE subsidiaries of a real estate investment trust. The lenders maintained, among other things, that the loan agreements with the SPEs stipulated that a SPE could not file for bankruptcy unless an independent director selected by the lenders approved it. The lenders also claimed that the SPEs’ chapter 11 filings were not made in good faith because the SPEs had no business necessity to file for bankruptcy and the trust exercised its authority to replace independent directors less than 30 days before the bankruptcy filings.

Because the new directors had knowledge in real estate, commercial mortgage-backed securities, and bankruptcy matters, the General Growth court held that replacing the SPEs’ independent directors with new independent directors days before the bankruptcy filings was not in bad faith. Despite the SPEs’ healthy cash flows, bankruptcy remote arrangements, and lack of debt defaults, the court ruled that the chapter 11 petitions were not done in bad faith. In determining the legitimacy of the chapter 11 files, the court concluded that it could take into account the interests of the entire group of related borrowers as well as the interests of each individual debtor.

The requirement under applicable Alabama law for independent directors to consider not only the interests of creditors, as mandated in the charter or other organizational documents, but also the interests of shareholders is one of the potential flaws in the bankruptcy remote SPE structure brought to light by General Growth. As a result, an independent director or manager who simply votes to prevent a bankruptcy filing at the request of a secured creditor without considering the impact on shareholders may be found to have breached his or her fiduciary obligations of care and loyalty. See 547 B.R. 899 (Bankr. N.D. Ill. 2016) In re Lake Michigan Beach Pottawattamie Resort LLC (a “blocking” member provision in the membership agreement of a special purpose limited liability company was unenforceable because it did not require the member to comply with its fiduciary obligations under applicable non-bankruptcy law).

Courts dispute over the enforceability of blocking clauses, particularly “golden shares,” which provide a shareholder the right to preempt a bankruptcy filing when utilized in a bankruptcy context. In Lexington Hospitality, for example, the bankruptcy court refused a motion to dismiss a bankruptcy case brought by an entity entirely owned by a creditor and holding a golden share/blocking provision because the court determined that the entity was not truly independent. 684–85 in 577 B.R. Furthermore, the court found in In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016) that a provision in a limited liability company’s governing document:

Seek federal bankruptcy relief

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 a “golden share” whose sole purpose and effect is to place the ultimate authority to eviscerate the right of that entity to seek federal bankruptcy relief in the hands of a single, minority equity holder [by means of a “golden share”

Id. at 265; see also In re Tara Retail Group, LLC, 2017 WL 1788428 (Bankr. N.D. W. Va. May 4, 2017) (despite having a golden share or blocking clause, a creditor’s silence confirmed the debtor’s bankruptcy filing), appeal denied, 2017 WL 2837015. (N.D. W. Va. June 30, 2017).

In In re Squire Court Partners, 574 B.R. 701, 704 (E.D. Ark. 2017), the court held that where a partnership agreement required the partners’ unanimous consent before the limited partnership could “file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy,” the bankruptcy court correctly dismissed a bankruptcy filing by the managing partner without the consent of the other partners.

In re Franchise Services of North America, Inc., 891 F.3d 198, is a fundamental case on this topic (5th Cir. 2018). In Franchise Services, the debtor amended its certificate of incorporation to provide that it could not “effect any Liquidation Event” (defined to include a bankruptcy filing) without the approval of the holders of a majority of both its preferred and common stock as a condition of an investment by a majority preferred stockholder controlled by one of the debtor’s creditors. “There is no prohibition in federal bankruptcy law against allowing a preferred shareholder the authority to prevent a voluntary bankruptcy filing just because the shareholder also happens to be [controlled by] an unsecured creditor,” the Fifth Circuit said. Ibid., p. 208. The Fifth Circuit rejected the notion that, even if a shareholder-citizen-citizen-citizen-citizen-citizen

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