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"Cleverly Insidious" Bankruptcy Waiver in SPE Operating Agreement Unenforceable As Matter of Public Policy

"Cleverly Insidious" Bankruptcy Waiver in SPE Operating Agreement Unenforceable As Matter of Public Policy

It is generally recognized that an outright contractual waiver of an entity’s right to file for bankruptcy is invalid as a matter of public policy.  Nevertheless, lenders sometimes attempt to prevent a borrower from seeking bankruptcy protection by, for example, providing for a waiver of the automatic stay or a bankruptcy discharge in a loan agreement, or conditioning a loan or other financing on a covenant, by-law or corporate charter provision that prohibits a bankruptcy filing or restricts the power of the borrower’s governing body to authorize such a filing.

One such restriction was recently addressed by the U.S. Bankruptcy Court for the District of Oregon in In re Bay Club Partners-472, LLC, 2014 BL 125871 (Bankr. D. Or. May 6, 2014).  The court ruled that a creditor possessed standing to seek dismissal of a chapter 11 case on the basis that the debtor— a limited liability company established as a special purpose entity ("SPE")— was not properly authorized to file for bankruptcy.  The court went on to rule, however, that  a restrictive covenant added at the creditor’s insistence to the debtor’s operating agreement prohibiting a bankruptcy filing was unenforceable and that the debtor accordingly was duly authorized to file for chapter 11 protection.

Waiver of Bankruptcy, "Cause" to Dismiss and Standing

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 maxim that a waiver of the right to file for bankruptcy is unenforceable because it violates public policy has long been the general rule.  See In re Weitzen, 3 F. Supp. 698, 698 (S.D.N.Y. 1933); Accord Continental Ins. Co. v. Thorpe Insulation Co. (In re Thorpe Insulation Co.), 671 F.3d 1011, 1026 (9th Cir. 2012); Wank v. Gordon (In re Wank), 505 B.R. 878, 887-88 (9th Cir. Bap 2014); NW. Bank & Trust Co. v. Edwards (In re Edwards), 439 B.R. 870, 874 (Bankr. C.C. Ill. 2010); Double v. Cole (In re Cole), 428 B.R. 747, 752 (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 173, 1177 (9th Cir. 2002).  By contrast, pre-bankruptcy waivers of the automatic stay are sometimes enforceable.  See, e.g., 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) (stating that "[s]ince the purpose of the stay is to protect creditors as well as the debtor, the debtor may not waive the automatic stay.").

Section 1112(b) of the Bankruptcy Code provides that a bankruptcy case may be dismissed for "cause," and provides a non-exclusive list of grounds that constitute cause.  Although not specifically enumerated, lack of authority to commence a bankruptcy case constitutes cause for dismissal under section 1112(b).  See In re NNN 123 N. Wacker, LLC, 2014 BL 146967, *2 (Bankr. N.D. Ill. May 27, 2014); In re ComScape Telecommunications, Inc., 423 B.R. 816, 830 (Bankr. S.D. Ohio 2010); In re A-Z Elec., LLC, 350 B.R. 886, 891 (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, *1 (Bankr. E.D.N.C. June 9, 2009); In re N2N Commerce, Inc., 405 B.R. 34, 41 (Bankr. D. Mass. 2009); In re Telluride Income Growth Ltd. P’ship, 311 B.R. 585, 591 (Bankr. D. Colo. 2004).

Not all parties in a bankruptcy case, however, have standing to raise such issues as due authorization.  "Standing" is the ability to commence litigation in a court of law.  It is a threshold issue—a court must determine whether a litigant has the legal capacity to pursue claims before the court can adjudicate the dispute.  Section 1109(b) of the Bankruptcy Code specifically provides that any "party in interest," including the debtor, the trustee, a committee of creditors or equity interest holders, a creditor or an indenture trustee, "may appear and may be heard on any issue" in a chapter 11 case.

Courts have sometimes disagreed as to whether a creditor has standing to raise the issue of proper authorization to file a bankruptcy petition on behalf of a legal entity.  See, e.g., In re Carolina Park Assocs., 430 B.R. 744, 749 (Bankr. D.S.C. 2010) (finding standing); In re Orchard at Hansen Park, LLC, 347 B.R. 822, 825-26 (Bankr. N.D. Tex. 2006) (same); In re Gucci, 174 B.R. 401, 412 (Bankr. S.D.N.Y. 1994) (standing depends on creditor’s stake in case); In re Giggles Restaurant, Inc., 103 B.R. 549, 555-56 (Bankr. D. N.J. 1989) (standing not limited to shareholders and directors).  But see In re Sterling Mining Co., 2009 BL 171156 (Bankr. D. Idaho Aug. 11, 2009) (creditor lacks standing); In re Southwest Equipment Rental, 152 B.R. 207 (Bankr. E.D. Tenn. 1992) (same).

In Bay Club Partners, the bankruptcy court considered both the ability of an SPE debtor to commence bankruptcy proceedings and whether certain parties possessed the necessary standing to challenge the validity of the bankruptcy filing.

Bay Club Partners

Bay Club Partners-472, LLC ("BCP") was formed as an Oregon limited liability company ("LLC") in 2005 for the purpose of acquiring, renovating and operating a large apartment complex in Arizona.  In November 2005, the predecessor in interest of Legg Mason Real Estate CDO I, Ltd. ("Legg Mason") loaned BCP approximately $24 million on a secured basis to acquire the property.

BCP, a manager-managed (as distinguished from a member-managed) LLC under Oregon law, is managed by Bay Club Management, LLC ("BCM").  BCP’s LLC operating agreement provides in relevant part that the manager "shall have the sole and exclusive authority to manage" BCP and that "[t]he affirmative consent (regardless of whether written, oral, or by course of conduct) of the Manager shall constitute the sole requisite for purposes of any provision of this Agreement, excepting only the dissolution of the Company which shall require the consent of the majority in interest of the Members."  It further states that "[a]ll other decisions concerning the business affairs of the Company shall be made by the Manager."

Notwithstanding this broad grant of authority to BCM, the BCP’s operating agreement contains a negative covenant providing that, until such time as the indebtedness incurred by BCP to acquire the property was paid in full:

[BCP] shall not institute proceedings to be adjudicated bankrupt or insolvent; or consent to the institution of bankruptcy or insolvency proceedings against it; or file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy; or consent to the appointment of a receiver, liquidator, assignee, trustee, sequestrator (or other similar official) of the Company or a substantial part of the Company’s property; or make any assignment for the benefit of creditors; or admit in writing its inability to pay its debts generally as they become due; or take any action in furtherance of any such action.

Although representatives of all BCP members at the time signed the operating agreement, there was no evidence that the members or their representatives discussed this restrictive covenant beforehand.  The non-bankruptcy covenant was included at the request of Legg Mason.        

BCP defaulted on the loan in January 2014.  Shortly afterward, BCP filed a chapter 11 petition in the District of Oregon.  The petition was signed by a representative of BCM.  It was accompanied by a document entitled "Written Consent and Resolutions of Bay Club Members," executed by or on behalf of three of BCP’s four members (representing 80 percent of BCP’s member ownership interests).  The remaining member, Trail Ranch Partners, LLC ("Trail Ranch"), actively opposed the bankruptcy filing.

Legg Mason moved to dismiss the chapter 11 case for cause under section 1112(b).  According to Legg Mason, the BCP’s operating agreement prohibited BCP from filing for bankruptcy protection, and BCM possessed no authority to cause BCP to file for bankruptcy without the affirmative votes of 100 percent of BCP’s members.  Trail Ranch later joined in the motion.  

The Bankruptcy Court’s Ruling

The bankruptcy court denied the motion to dismiss.  At the outset, the court addressed the standing issue.  The court explained that, despite the expansive language of section 1109(b) of the Bankruptcy Code, some courts outside of the Ninth Circuit have held that creditors do not have standing to seek dismissal of a business entity’s bankruptcy case because creditors are motivated more by self interest rather than concerns that would benefit the creditor body as a whole.  See, e.g., In re John Hicks Chrysler-Plymouth, Inc., 152 B.R. 503, 510 (Bankr. E.D. Tenn. 1992).  However, the court emphasized, the classic "pecuniary interest" test is applied in the Ninth Circuit (citing Fondiller v. Robertson (In re Fondiller), 707 F.2d 441 (9th Cir. 1983)).  Under this standard, only those persons "who are directly and adversely affected pecuniarily" by a bankruptcy case have standing to appear and be heard.

Given Legg Mason’s direct pecuniary interest as the only secured creditor in BCP’s chapter 11 case, the court ruled that Legg Mason had standing to seek dismissal of the case under both the pecuniary interest test and section 1109(b).  Even if it had concluded otherwise, the court noted, Trail Ranch had standing as a BCP member to prosecute the motion to dismiss, which it had joined. 

On the issue of the enforceability of the waiver of the right to file for bankruptcy protection prior to the repayment of the Legg Mason debt, the court stated that the parties’ arguments concerning the validity of the non-bankruptcy covenant under Oregon law were misplaced because federal law governs the issue.  In the Ninth Circuit, the court explained, the law is "very clear" that a debtor’s prepetition waiver of the right to file a bankruptcy case is unenforceable because it violates public policy.  The court acknowledged the absence of any evidence that Legg Mason insisted on a bankruptcy waiver in its loan agreement with BCP.  Instead, the court wrote, Legg Mason’s conduct in requesting that a bankruptcy waiver be included in BCP’s operating agreement along with other restrictive covenants without any discussion among BCP’s members was "more cleverly insidious."  The bankruptcy waiver in the operating agreement, the court wrote, "is no less the maneuver of an ‘astute creditor’ to preclude [BCP] from availing itself of the protections of the Bankruptcy Code prepetition, and it is unenforceable as such, as a matter of public policy."

Finally, the court ruled that BCP’s chapter 11 filing was properly authorized by BCM, despite the refusal of Trail Ranch to sign the consent resolution.  Under the operating agreement, the court explained, BCM clearly had the authority to initiate a chapter 11 case on BCP’s behalf.

Accordingly, the court denied the motion to dismiss BCP’s chapter 11 case.       

Outlook

The enforceability of bankruptcy waivers or restrictions frequently arises in the context of SPEs that, like the debtor in Bay Club Partners, are designed to be "bankruptcy remote" as a way to encourage investment and limit the risks of both investors and lenders.  See, e.g., In re Gen. Growth Props., Inc., 409 B.R. 43, 54 (Bankr. S.D.N.Y. 2009) (denying dismissal of chapter 11 cases where loan agreement with bankruptcy remote debtor provided that debtor could not file for bankruptcy without approval of independent director that represented lender’s interest); see also Sheri P. Chromow & K.C. McDaniel, Surviving a CMBS Bankruptcy, Modern Real Est. Transactions 747, 754 (ALI-ABA Continuing Legal Education, Course of Study No. SJ004, 2003) ("Case law has rejected the idea of limiting the power of directors or requiring them to refuse a vote in favor of bankruptcy.").  Bay Club Partners is representative of the dim view traditionally taken by bankruptcy courts confronting such waivers. 

The blanket rule against waiver in this context, as distinguished from cases involving 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 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).  This is one of the many issues being considered by the American Bankruptcy Institute’s Commission to Study the Reform of Chapter 11. 

At this juncture, however, Bay Club Partners suggests that lenders and investors in the Ninth Circuit should continue to be skeptical that SPEs are truly bankruptcy remote.

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