In distressed situations and workouts, lenders often trade forbearance and additional funding for concessions that make it easier to foreclose if the debtor commits new defaults or files a bankruptcy. Two recent Bankruptcy Court decisions refused to enforce provisions in forbearance agreements that aimed to block bankruptcy filings by the debtors.1 In both cases, the Bankruptcy Courts ruled that the appointment of the lender as a “special member” with veto power over a bankruptcy filing was void as contrary to federal public policy.
In Lake Michigan Beach, Bankruptcy Judge Timothy A. Barnes of the Northern District of Illinois stated that “[i]n the same way that individuals may not contract away their bankruptcy rights, corporations should be similarly constrained.” In Intervention Energy, Bankruptcy Judge Kevin J. Carey of the District of Delaware stated that “it is axiomatic that a debtor may not contract away the right to discharge in bankruptcy.” These cases illustrate the risk of lenders in workouts going beyond the techniques commonly used in financing transactions to make the collateral owner “bankruptcy remote” by, among other things, requiring an independent person to be appointed as a noneconomic special member who must approve the filing of a bankruptcy petition.2
A bankruptcy remote structure in new financing transactions is created by forming a separate entity, often a wholly owned limited liability company (LLC), the single purpose of which is owning and operating a single property or business. The entity becomes bankruptcy remote by isolating the property and its income from the creditors of the parent and its unrelated business operations. This is accomplished by requiring separateness of the borrower from the parent in terms of the borrower’s banking, liabilities, operations, recordkeeping, and dealings with creditors.
Bankruptcy remote structures also generally require the appointment of one or two special members who possess veto power over “material actions” of the bankruptcy remote entity, such as the sale of substantially all of the borrower’s assets or commencement of a voluntary bankruptcy case. These special members may not be insiders of the borrower and may have other qualifications relating to industry experience or service as independent members of other entities. Service companies will supply independent members for a fee.
The cases in question went beyond this approach to establishing a bankruptcy remote structure. In Lake Michigan Beach, the lender required an amendment to the debtor’s LLC agreement as part of a forbearance agreement following a default by the debtor. The amendment required the appointment of the lender as a special member with no ownership interest, but with a veto power over the filing of bankruptcy proceedings. After another default, the lender began a foreclosure that was stayed when the debtor filed a Chapter 11 proceeding—without obtaining the approval of the lender.
The Bankruptcy Court rejected the lender’s contention that the bankruptcy filing was unauthorized due to the lack of consent by the lender in its capacity as special member. The Bankruptcy Court weighed the conflict between state governance laws and the appointment of a special member, which it recognized to be a “lynchpin” of special purpose, bankruptcy remote entities. The Bankruptcy Court stated that “[f]or public policy reasons, a debtor may not contract away the right to a discharge in bankruptcy.”
Similarly, the court noted that a so-called “blocking manager” cannot be appointed “solely for the purpose of voting ‘no’ to a bankruptcy filing because of the desires of the secured creditor” because fiduciary duties apply. Rather, enforceable bankruptcy remote structures must allow the blocking member or director to adhere to his or her “normal 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 that they were chosen by.”
The court also invalidated an exculpation provision inserted in the operating agreement that absolved the lender (as special member) from any fiduciary duty to the debtor or its members as contrary to public policy. This blanket exculpation conflicted with Michigan LLC law imposing a duty of loyalty and care of an ordinarily prudent person. So great was the conflict that the exculpation was not saved because it only operated “to the fullest extent permitted by applicable law.” Michigan law did not allow the lender solely to consider its own best interest if it were to vote as a special member, so its veto power over the debtor’s bankruptcy was invalid.
In Intervention Energy, the debtor also entered into a forbearance agreement with its lender prior to filing for bankruptcy. The forbearance agreement included the following “consent provision” as a condition precedent to its effectiveness:
The Administrative Agent shall have received a fully executed amendment to the limited liability company agreement of the Parent in form and substance satisfactory to the Administrative Agent (i) admitting [the lender] or its Affiliate as a member of the Parent with one common unit and (ii) amending such limited liability company agreement to require approval of each holder of common units of the Parent prior to any voluntary filing for bankruptcy protection for the Parent of the Company.
The debtor amended its limited liability company agreement accordingly, but did not comply with the new consent provision when it subsequently commenced a bankruptcy proceeding without its lender’s approval. The lender filed a motion to dismiss the bankruptcy on the grounds that the debtor lacked authority to file its Chapter 11 petition.
The Bankruptcy Court held that the consent provision was void as contrary to federal public policy. Unlike Barnes in Lake Michigan Beach, Carey relied solely on federal public policy and explicitly refused to delve into the fiduciary duty implications under Delaware’s Limited Liability Company Act. Nevertheless, Carey placed significant weight on the fact that the special member appointed by the lender “owes no duty to anyone but itself in connection with an LLC’s decision to seek bankruptcy relief” and stated that such a provision “is tantamount to an absolute waiver of the right, and, even if arguably permitted by state law, is void as contrary to federal public policy.”
Crafting Bankruptcy Remote Structures
In light of Lake Michigan Beach and Intervention Energy, lenders should be cautious in crafting bankruptcy remote structures. First, it is important to understand that bankruptcy “remoteness” does not guarantee an entity is bankruptcy “proof” because of the risk that a Bankruptcy Court will scrutinize the parties’ loan documents, organizational documents, and conduct thereunder. Poorly crafted provisions may be circumvented if the debtor can replace the original independent members with others chosen to be more likely to approve a bankruptcy filing.
Second, putting the lender or its employees in control in a special member or manager role may increase the scrutiny of Bankruptcy Courts. In Lake Michigan Beach Barnes ruled that public policy can trump contractual exculpation from statutory fiduciary duties and void a special member’s veto due to inherent conflict of interest.
A safer approach to bankruptcy remoteness could be the appointment of an “independent” manager, often supplied by a service company to perform that role for a fee. Such a manager probably would not rush to file a bankruptcy merely to protect the equity interests of the debtor, but theoretically could, in the exercise of his or her fiduciary duties, approve a bankruptcy filing if it were in the best interests of the entity and all creditors. Although it was not explicitly raised in Lake Michigan Beach or Intervention Energy, lenders always should exercise caution if they acquire a substantial voting equity interest in a debtor, because they can be deemed to be an “insider” and thus exposed to lender liability claims for breach of fiduciary duty, liability for mistakes in governance, and even enhanced liability for preferences and fraudulent transfers.
Third, the lender must carefully consider whether the state of organization (and hence the governing law) of a bankruptcy remote entity is appropriate. The Illinois LLC Act, like the Michigan LLC statute cited earlier, affirmatively imposes duties of due care and loyalty on LLC managers and members in member-managed LLCs. In contrast, Delaware LLCs often are chosen because the Delaware LLC Act flexibly allows exculpation from all fiduciary duties except the duty of loyalty. Nevertheless, in Delaware, the veto of a lender as an LLC member might not pass muster because of the potentially conflicting loyalties of the member. This is especially true when the special member owes no duty to the LLC because the member’s veto rights were “bought and paid for” by the lender. In this situation, Bankruptcy Courts are likely to rely on federal public policy to void the consent provision.
Fourth, the lender should consider incorporating language into the consent provision that provides for an independent special member that shall consider only the interests of the LLC. The lender may also consider adding language that the special member shall have a fiduciary duty of loyalty and duty of care (if otherwise imposed by the LLC Act). An example of a provision that incorporates this language is:
To the fullest extent permitted by law, the Independent Manager shall consider only the interests of the Company, including its respective creditors, in acting or otherwise voting on any Material Action. All right, power and authority of the Independent Manager shall be limited to the extent necessary to exercise those rights and perform those duties specifically set forth in this Agreement. The Independent Manager shall have a fiduciary duty of loyalty and care similar to that of a director of a business corporation organized under the General Corporation Law of the State of Delaware. No Independent Manager shall at any time serve as trustee in bankruptcy for any Affiliate of the Company.
Fifth, merely appointing a blocking director or manager is not sufficient for bankruptcy remoteness. Best practices require, among other things, specification of the substantive qualifications and nonaffiliation of independent members and managers and advance notice of selection, removal, or replacement of such persons. They also require that the entity only have a single business purpose and prescribe many affirmative and negative “separateness” practices designed to avoid creditor confusion or commingling of the assets, liabilities, and financial affairs of the debtor with affiliates. This step is necessary to prevent the bankruptcy remote entity from acquiring creditors that might pursue an involuntary bankruptcy or allowing a Bankruptcy Court to substantively consolidate the assets and liabilities of the debtor with other affiliates.
Finally, decisions like Lake Michigan Beach and Intervention Energy suggest that lenders should consider backing up the bankruptcy remote structures with springing recourse to guarantors for the full debt if the bankruptcy remote requirements are violated or a voluntary or collusive bankruptcy is filed, or to recover the lender’s loss due to the violation of the separateness provisions or misapplication of cash collateral. Such “bad boy” guaranties are enforceable, but must be carefully drafted to avoid entangling the guarantor and borrower to such a degree that the bankruptcy remoteness of the borrower is compromised.