What does it take to be voluntary?: Courts negate blocking director/member LLC provisions

Two recent decisions by bankruptcy courts, In re Lake Michigan Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. April 5, 2016) and In re Intervention Energy Holdings, LLC, case no. 16-11247 (Bankr. Del. June 3, 2016), have cast doubt on the viability of a strategy often used by lenders to undermine borrowers’ ability to file a bankruptcy petition. While the two decisions rely on different rationales, the result is that lenders should recalibrate their expectations regarding whether borrowers can be prevented from filing bankruptcy through drafting or structural means.

In both cases the lenders sought the dismissal of voluntary bankruptcy petitions on the theory that the petitions were not “voluntary” because they were not properly authorized under the governing limited liability company agreements. The decisions are but the latest iterations of a long-running debate concerning the extent to which lenders can prevent or hamper the ability of borrowers to file for bankruptcy. The general proposition is that, as a matter of public policy, a debtor may not waive its right to file a bankruptcy petition, and that waivers of the right to file for bankruptcy are unenforceable. On the other hand, as a general matter of corporate law, the filing of a bankruptcy petition must be properly authorized by the board of directors, and creative transactional lawyers have long endeavored to find a way to impede or frustrate the ability of borrowers to file for bankruptcy by creating conditions to corporate authorization without running afoul of the prohibition on outright waiver. One popular tactic, sometimes referred to as the blocking director/member construct, involves provisions in the corporate charter that bar the filing of a voluntary bankruptcy petition without unanimous consent of all directors, coupled with the appointment of a director or directors independent of the borrower’s management.

The bellwether recent case on this subject is In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009), in which the New York bankruptcy court sustained chapter 11 filings by a real estate holding company and many single-purpose entity subsidiaries notwithstanding the fact that the single purpose entities had been required to appoint independent directors, whose consent was required for a bankruptcy filing. In the cases of some of the subsidiaries, the independent directors approved of a bankruptcy filing. In other cases, management simply terminated the independent directors and replaced them with other independent directors who voted to permit the bankruptcy filings. The court found that the corporate charters did not prohibit the firing of the independent directors, and further held that the directors had acted properly in light of their fiduciary responsibilities to the debtors, notwithstanding the intention of many lenders that the purpose of the independent director provisions was to protect the interests of the lenders.

The lender in Lake Michigan Beach appears to have learned the lessons of General Growth Properties and attempted to draft around them. The borrower was a Michigan limited liability corporation that had included in its operating agreement provisions that barred the filing of a voluntary bankruptcy petition unless there was unanimous consent of all LLC members, including a member designated by the lender. The LLC operating agreement also contained provisions that absolved the lender-designee member from any fiduciary duties to the borrower or to non-lender creditors generally. This structure appeared to batten down both of the General Growth Properties escape hatches, as management could not terminate the lender-designee member, and the fiduciary responsibilities were waived.

However, the Lake Michigan Beach court ruled that the fiduciary responsibility waiver was the Achilles’ Heel of this structure. It determined that the fiduciary-duty waiver violated a provision of Michigan law that requires that members of an LLC owe a fiduciary duty to the LLC. Accordingly, the court voided the requirement that all members of the LLC consent to a bankruptcy filing, and found that the debtor had voluntarily filed for bankruptcy notwithstanding the lack of consent of the lender-designated member.

In Intervention Energy the lender received a unit of the borrower, a Delaware LLC, and the LLC operating agreement required, for a bankruptcy filing, unanimous consent of all unit-holders. The lender attempted to distinguish Lake Michigan Beach, arguing that Delaware law is far more permissive than Michigan law in permitting an LLC operating agreement to contain waivers of a director’s fiduciary duties. But the Intervention Energy court did not follow General Growth Properties and Lake Michigan Beach in centering its analysis on the fiduciary duties of directors, and indeed expressly declined to interpret state LLC law. Instead, it ruled that, under federal law, a provision in an LLC governance document that permits a creditor to block a bankruptcy filing is “tantamount to an absolute waiver of that right” and hence void as contrary to federal public policy. The end result, as in Lake Michigan Beach, was that the court ignored the vote of the creditor-designee member and deemed that debtor had sufficient consent from its members to file a voluntary petition.

Intervention Energy is the more far-reaching of the two decisions. Delaware is of greater national significance than Michigan both as a bankruptcy venue and as the governing law for corporate entities. And a decision based on federal public policy cuts far more widely than does an interpretation of state law.

Taken together, the two decisions show that bankruptcy judges are generally reluctant to find debtors ineligible for bankruptcy, and that lenders should not be able to rely on their ability to prevent bankruptcy filings through such means, notwithstanding seemingly favorable provisions in state statutes. Indeed, the decisions highlight the importance of other single-purpose entity provisions, which can, if used appropriately, reduce the likelihood of a bankruptcy filing without impermissibly affecting the right to file.