Lender-Inspired Operating Agreement Limitations on a Limited Liability Company’s Authority to Seek Bankruptcy Relief: “Perfect” Is the “Enemy” of the Achievable “Good”

[1]A new business entity formed today more likely than not will be formed as a limited liability company (LLC). From 2013 through 2015, for example, of the approximate 497,000 entities formed in Delaware as measured by filings with the state,[2] and excluding the 4,265 statutory trusts formed, approximately 359,000 were LLCs (72 percent) compared to the approximately 109,000 corporations and just under 29,000 limited partnerships.[3] The increasing use of the LLC form is driven in part by the flexibility inherent with LLCs, which are fundamentally creatures of contract. Similar to other states’ statutory schemes, the Delaware Limited Liability Company Act is in large part a “default statute”: Many of its statutory provisions explicitly apply only to the extent the LLC’s operating agreement does not provide otherwise, and the concept of “freedom of contract” is expressly incorporated into the Act.[4] Because of the inherent flexibility of the LLC form due to its ability to organize and operate pursuant to the contractual undertakings of their members, lenders often prefer to lend to LLCs and may require the creation of an LLC to be the borrower as a condition to lending.

Lenders also may prefer to lend to a purported “bankruptcy remote” entity, and may require its borrower LLC’s operating agreement to include restrictions on the company’s ability to voluntarily commence a bankruptcy case as a condition to lending. Whether an entity has properly exercised its authority to commence a bankruptcy case is a matter of state law; thus, the provisions of the borrower LLC’s operating agreement and the applicable law of the state of the LLC’s formation with respect to the management of the company will control. But, as has been recognized by recent case law, such “bankruptcy blocking” provisions may run afoul of both state limited liability company laws or of the federal policy in favor of access to bankruptcy relief. These cases suggest that lenders sometimes have gone “a bridge too far”[5] in attempting to make their borrower LLC’s bankruptcy remote.

The first of these decisions (decided on April 5, 2016) is In re Lake Michigan Beach Pottawatamie Resort LLC,[6] a decision based on Michigan’s limited liability company law. In Lake Michigan Beach, as a condition of forbearance, the forbearing lender obtained the borrower LLC’s agreement to amend its operating agreement to make the lender a special member of the LLC for a single purpose: approval or disapproval of any material action, including whether to commence a voluntary bankruptcy case. The operating agreement as amended entitled the lender/special member 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 or factors affecting the Company or the Members.[7]

The Lake Michigan Beach court determined that this operating agreement provision, not requiring the lender/special member to consider the interests of the LLC in exercising its authority, was contrary to Michigan law, noting in dicta that the presence of duties owed to a debtor LLC is the “redeeming factor that permits the blocking director/member construct,”[8] which is the “lynchpin that holds together a bankruptcy remote special purpose entity.”[9] Accordingly, the Lake Michigan Beach court held that the “blocking member” provision of the operating agreement was void under state law, which had the effect of validating the commencement of the bankruptcy case filed by the other members without the lender/special member’s approval. However, the construct noted by the Lake Michigan Beach court — duties owed to the LLC — is one that most lenders likely would seek to avoid, as taking on such duties could open the lender to breach-of-fiduciary-duty and/or lender-liability claims.

Second (decided on June 3, 2016) is In re Intervention Energy Holdings LLC,[10] in which, similar to Lake Michigan, a forbearing creditor obtained the agreement of the borrower/future debtor LLC to amend its operating agreement, this time to (1) provide the creditor with a single common membership unit (of the 22,000,001 issued units) and (2) require the holders of all common membership units to approve commencement of a voluntary bankruptcy case. Also similar to Lake Michigan, the operating agreement allowed the forbearing creditor/member to consider only its own interests in deciding whether to commence a bankruptcy case without regard to the interests of the company or other creditors. The Delaware bankruptcy court found that the sole purpose and effect of such an agreement was to place into the hands of the forbearing creditor, “which owes no duty to anyone but itself,” the ability to “eviscerate the right of [the company] to seek federal bankruptcy relief.” The Delaware bankruptcy court held that such was unenforceable as it was contrary to established, and inviolate, federal public policy favoring access of persons and entities to federal bankruptcy relief, finding that the arrangement “was tantamount to an absolute waiver of that right.” In deciding the matter on federal public policy grounds, the Delaware bankruptcy court expressly declined to reach the state law issue considered by the Lake Michigan Beach court as to whether operating agreement provisions like those involved in Intervention Energy Holdings are proper under Delaware’s limited liability company law.[11]

Third (decided on Sept. 15, 2017) is In re Lexington Hospitality Group LLC.[12] Similar to Intervention Energy Holdings and Lake Michigan Beach, the initial operating agreement for the company (created at a time when there was no lender to the company) contained no “lender-inspired” bankruptcy-blocking provisions, but when the company obtained a loan to finance its acquisition of a hotel and conference center, the lender conditioned the financing on the LLC’s agreement to add an affiliate of the lender as a 30 percent member (which later became 50 percent), which membership would continue so long as the loan remained unpaid. The operating agreement also was amended to include two contradictory bankruptcy-commencement-related provisions: (1) the addition of an “independent manager” charged with the decision of whether or not to commence a bankruptcy, but only after a vote of 75 percent of the members had authorized a filing; and (2) the prevention of the company from filing a bankruptcy case without the advance, written consent of the lender and all members of the company (which, of course, would include the lender’s affiliate).

After recognizing both the contradictory nature of the two blocking provisions, and the ineffectual “window dressing” of the independent manager (as his role was subject to the 75 percent threshold, which could never be met if the lender’s affiliate voted “no”), the Kentucky bankruptcy court held both that the “bankruptcy blocking provisions” were unenforceable as they were contrary to federal public policy and that, after excising the blocking provisions as being contrary to public policy, the LLC’s bankruptcy case was properly commenced by the company’s member-manager under the Kentucky limited liability company statute. The Kentucky court reasoned as follows, relying in large part on Intervention Energy Holdings:

Parties to an operating agreement generally have the freedom to contract.… But there is a strong federal public policy in favor of allowing individuals and entities their right to a fresh start in bankruptcy. “It has been said many times and many ways: ‘[P]repetition agreements purporting to interfere with a debtors rights under the Bankruptcy Code are not enforceable.’” In re Intervention Energy Holdings LLC, 553 B.R. 258, 263 (Bankr D. Del. 2016) (quoting MBNA Am. Bank N.A. v. Trans World Airlines Inc. (In re Trans World Airlines Inc.), 275 B.R. 712, 723 (Bankr. D. Del. 2002)).

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The bankruptcy court in Intervention Energy Holdings explained:

A provision in a limited liability company governance 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.[13]

Thus, based on Intervention Energy Holdings and Lexington Hospitality Group, even if valid under state law, a “perfect” bankruptcy-blocking provision in an operating agreement (i.e., one that gives the lender, in effect, a “veto”) is void as being contrary to federal public policy when (1) it gives a minority equityholder, whose primary relationship with the company is that of creditor and not equityholder, the ultimate authority over a bankruptcy filing, and (2) such equityholder owes no duty to anyone but itself in deciding whether a bankruptcy should be filed. The consequence of invalidation of such contractual provisions is that it leaves the decision to file a bankruptcy case with the people, the principals of the company (in their guises as members or managers), that the lender was trying to prevent from having sole control over the decision, and which likely have their own self-interests more in mind in making the decision. In effect, the desire for the perfect bankruptcy-blocking mechanism very well could result in much less robust protection for the lender seeking to avoid a bankruptcy than it thought it had bargained for.[14]

Although not in the context of an LLC, the recent decision (July 7, 2017) in In re Squire Court Partners Limited Partnership[15] may be instructive. The limited partnership in Squire Court Partners had three partners: a general partner (NHDC Texas) owning 0.01 percent of the company, a limited partner owing 99.98 percent of the company, and another limited partner owning 0.01 percent. An affiliate of NHDC Texas guaranteed the company’s mortgage obligations. The partnership agreement authorized NHDC Texas to manage the partnership but required the unanimous consent of all partners to file for bankruptcy. The partnership defaulted on its mortgage obligations, the lender accelerated, and the guarantor refused to pay, causing the limited partners to sue the guarantor in state court. After seeking but failing to obtain consent from the limited partners, NHDC Texas caused the partnership to file for bankruptcy relief. The bankruptcy court held that NHDC Texas had filed the case without proper authority and granted the limited partners’ motion to dismiss. On appeal, NHDC Texas (and the guarantor) argued, based in part on Lake Michigan Beach and Intervention Energy Holdings, that (1) federal public policy required a fiduciary to decide whether to seek bankruptcy relief, (2) the limited partners, which did not owe any fiduciary duties to the partnership and did not consider the interests of the partnership in not consenting to the filing, had exercised an improper and self-interested veto, and (3) the decision by the limited partners to enforce the guaranty rather than seek bankruptcy protection was not in the best interests of the partnership.

In affirming the bankruptcy court’s holding that the bankruptcy case had been commenced without requisite state law authority (without the consent of the limited partners), the district court distinguished the situation in Squire Court Partners from Lake Michigan Beach and Intervention Energy Holdings, noting:

While each case ... involves a different contractual provision, in all of the cases the provision amounted to a debtor agreeing to a prepetition waiver. Moreover, each case involved a creditor limiting a debtor’s right to seek bankruptcy relief as a condition of supplying credit. Each of these blocking provisions violated federal public policy.

None of these cases, however, stands for the more general proposition that a nonfiduciary cannot have a controlling role in the decision making process when an entity considers bankruptcy relief.

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The appellants have provided the Court with no case holding that a bona fide equity owner must hold a fiduciary position before it can vote on whether to file a bankruptcy petition....[16]

The Squire Court Partners decision suggests two potential avenues for lenders seeking bankruptcy remoteness for their borrowers, neither of which is the “perfect” solution. One is becoming fairly routine in operating agreements for LLCs involved in lending transactions: the inclusion of one or more truly independent managers, directors or members who, but for participating in the decision of whether to file for bankruptcy, have no other rights in or obligations to the company.[17] Although it does not appear that this construct has been challenged in litigation, and even if it had been suggested or required by a lender as a condition to financing, the independent manager/director/member construct could be acceptable to a court following the reasoning of decisions discussed above, because even the person it is not a “fiduciary” in the strictest sense, the independent manager/director/member nevertheless should not be seen as self-interested, and thus conflicted, in the bankruptcy decision-making process, as is the lender/special member or an affiliate of the lender. “Truly independent” in this context clearly means a person not employed by the lender or an affiliate of the lender.[18] Because, in the cases discussed above, it was the status of the lender/member as really a creditor, and not independent in the sense that it likely could not divorce its interests from those of the company or the company’s creditors in deciding whether to commence a bankruptcy case, it is likely that the (truly) independent manager/director/member construct would not be seen by a bankruptcy court as being “tantamount to an absolute waiver” of the right to seek bankruptcy relief, or thus “contrary to federal public policy.”[19]

Another approach, although one that carries its own unique set of problems with it, is implied by the Squire Court Partners decision. What if a lender, in addition to lending to the LLC, also infused equity into the company such that it could be considered a “bona fide” equityholder in the entity? Would the lender then be looked at differently by courts after it decided against a bankruptcy filing by its borrower? Of course, infusion of equity alongside a loan certainly is not a typical business model for lenders, but sophisticated capital structures can and sometimes do include the same party as equityholder, unsecured lender and secured lender in the same entity. Issues of fiduciary duty and lender liability aside (which might be so pervasive and serious enough to end the inquiry at its beginning), the cost and risks associated with a bankruptcy process might be sufficiently ascertainable and measurable so as to outweigh the risk of no return on the equity piece supporting the de facto blocking position obtained by the lender.

Lenders can be expected to do all they can to minimize risk. Lending to bankruptcy remote borrowers is among the tools lenders seek to use in doing so. The perceived “perfect” tool in achieving that end — contractual “bankruptcy blocking” provisions, however couched — perhaps is not perfect after all, as courts have shown an unwillingness to respect such provisions. Further, they have the additional risk of putting the bankruptcy decision into the hands of self-interested members or managers. Better that the “good” (but not perfect) tool be used: the appointment of truly independent managers, members or directors that must take the interests of the company and its creditors into account in commencing a bankruptcy case, and then, when the time comes, persuading that person or persons that a bankruptcy filing is not in the best interests of the company or its creditors under the then-prevailing facts and circumstances. A “perfect” solution that is ignored is not much “good.”