A Brief Guide to Automatic Stay Waivers, Bankruptcy Remoteness, and Bad Boy Guarantees
- A borrower’s pre-bankruptcy waiver of the automatic stay is more likely to be enforced if contained in a forbearance agreement or an agreement approved by the court in a previous bankruptcy case.
- A bankruptcy remote organizational structure that includes a blocking director may be invalidated by a court if it permits a director to disregard fiduciary duties.
- A bad boy or springing guarantee under which the guarantor’s liability is triggered by the borrower’s bankruptcy filing is generally enforceable.
Astute lenders are always looking for ways to minimize exposure, protect remedies, and maximize recoveries in connection with a loan, especially with respect to borrowers that have the potential to become financially distressed. Some of these efforts have been directed toward minimizing the likelihood of a borrower’s bankruptcy filing by making the borrower “bankruptcy remote,” such as by implementing a “blocking director” organizational structure. Others involve attempts to structure a loan transaction to ensure as nearly as possible that, despite a bankruptcy filing by or against the borrower, the lender can exercise its remedies without unreasonable delay—by means of, for example, a pre-bankruptcy waiver of the automatic stay or an agreement not to contest a motion for stay relief—or can look to an alternate source for repayment under a “bad boy” or “springing” guarantee.
Depending on the jurisdiction involved and the particular circumstances, including the terms of the relevant documents, these mechanisms may or may not be enforceable. Here, we briefly offer some guidance on what may or may not pass muster under the relevant case law in connection with waivers of the automatic stay, bankruptcy remote structures, and bad boy guarantees.
Waivers of the Automatic Stay
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 general rule as a matter of public policy has been that a waiver of the right to file for bankruptcy is unenforceable. See In re Weitzen, 3 F. Supp. 698 (S.D.N.Y. 1933); accord Continental Ins. Co. v. Thorpe Insulation Co. (In re Thorpe Insulation Co.), 671 F.3d 1011 (9th Cir. 2012); Wank v. Gordon (In re Wank), 505 B.R. 878 (B.A.P. 9th Cir. 2014); Nw. Bank & Trust Co. v. Edwards (In re Edwards), 439 B.R. 870 (Bankr. C.D. Ill. 2010); Double v. Cole (In re Cole), 428 B.R. 747 (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 1173, 1177 (9th Cir. 2002).
Pre-bankruptcy waivers of the automatic stay, however, are sometimes enforceable. See, e.g., In re Bryan Road, LLC, 382 B.R. 844, 849 (Bankr. S.D. Fla. 2008) (setting forth factors for court to consider in deciding whether to enforce stay relief agreement, including: (i) sophistication of waiving party; (ii) consideration for waiver, including creditor’s risk and length of time covered by waiver; (iii) whether other parties are affected; and (iv) feasibility of debtor’s plan) (citing In re Desai, 282 B.R. 527, 532 (Bankr. S.D. Ga. 2002)); In re Frye, 320 B.R. 786 (Bankr. D. Vt. 2005) (although prepetition waiver not per se enforceable, waiver would be enforced unless debtor could show sufficient equity in property, sufficient likelihood of effective reorganization, or sufficient prejudice to other creditors); In re Excelsior Henderson Motorcycle Mfg. Co., 273 B.R. 920 (Bankr. S.D. Fla. 2002) (enforcing a prepetition agreement); In re Atrium High Point L.P., 189 B.R. 599 (Bankr. M.D.N.C. 1995) (prepetition waivers by debtor of automatic stay protection are enforceable in appropriate cases where enforcement does not violate public policy concerns, but are not binding on third-party creditors); In re Darrel Creek Associates, L.P., 187 B.R. 908, 910 (Bankr. D.S.C. 1995) (prepetition waivers are enforceable in appropriate circumstances, and such agreements function as a factor in determining whether relief from stay may be granted); In re Powers, 170 B.R. 480 (Bankr. D. Mass. 1994) (same); In re Cheeks, 167 B.R. 817 (Bankr. D.S.C. 1994) (prepetition agreements are enforceable on policy grounds of encouraging out-of-court restructurings and settlements, but waivers are not self-executing and are not binding on third parties); In re Club Tower L.P., 138 B.R. 307 (Bankr. N.D. Ga. 1991) (prepetition agreement granting creditor relief from stay was binding on parties where bankruptcy was filed in bad faith); In re Citadel Properties, Inc., 86 B.R. 275 (Bankr. M.D. Fla. 1988) (same).
Courts have typically enforced prepetition stay waivers as part of forbearance agreements, as distinguished from original loan documentation, or agreements that have been approved by courts in previous bankruptcy cases. See Bryan Road, 382 B.R. at 848; In re BGM Pasadena, LLC, 2016 BL 134299, *3 (Bankr. C.D. Cal. Apr. 27, 2016) (“While it is true that courts have generally treated waivers of the automatic stay as unenforceable when they are contained in prepetition agreements between a lender and a borrower (because the interests of third parties, such as unsecured creditors, for whose benefit the automatic stay exists were not considered at the time the agreement was made), the same cannot be said of waivers that are approved after notice and an opportunity for hearing in the context of an earlier bankruptcy case”); In re DB Capital Holdings, LLC, 454 B.R. 804, 816 (Bankr. D. Colo. 2011) (prepetition stay waivers may be enforced if part of confirmed plan or stipulation resolving earlier motion for relief, but otherwise “appear to conflict with the policies and purposes of the Bankruptcy Code, and should not be enforced.”); Atrium High Point, 189 B.R. at 607 (waiver in plan of reorganization confirmed in previous chapter 11 case).
Many courts which have enforced prepetition waivers of the stay have reasoned that enforcement furthers the legitimate public policy of encouraging out-of-court restructurings and settlements. See, e.g., Cheeks, 167 B.R. at 818 (“Perhaps the most compelling reason for enforcement of the [waiver] is to further the public policy in favor of encouraging out-of-court restructuring and settlement. . . . Bankruptcy courts may be an appropriate forum for resolving many of society’s problems, but some disputes are best decided through other means.”) (citation omitted); Powers, 170 B.R. at 483; Club Tower, L.P., 138 B.R. at 311.
Although the enforceability of prepetition stay waivers under appropriate circumstances is the majority view, some courts have rejected this approach, principally due to the resulting prejudice to creditors other than the beneficiary of the waiver. See, e.g., Ostano Commerzanstalt v. Telewide Systems, Inc., 790 F.2d 206, 207 (2d Cir. 1986) (“Since the purpose of the stay is to protect creditors as well as the debtor, the debtor may not waive the automatic stay”); Matter of Pease, 195 B.R. 431, 434 (Bankr. D. Neb. 1996) (“the pre-bankruptcy debtor simply does not have the capacity to waive rights bestowed by the Bankruptcy Code upon a debtor in possession, particularly where those rights are as fundamental as the automatic stay.”); In re Jenkins Court Assoc. L.P., 181 B.R. 33 (Bankr. E.D. Pa. 1995) (refusing to enforce prepetition waiver agreement without further development of facts); Farm Credit of Cent. Florida, ACA v. Polk, 160 B.R. 870 (M.D. Fla. 1993) (same); In re Sky Group Int’l, Inc., 108 B.R. 86 (Bankr. W.D. Pa. 1989) (prepetition waiver was not self-executing or per se enforceable).
Courts have been critical of prepetition stay waivers in cases involving single asset debtors, reasoning that such a waiver too closely approximates a prohibited waiver of the right to file for bankruptcy. See DB Capital, 454 B.R. at 814; Jenkins, 181 B.R. at 37; accord In re Triple A & R Capital Inv., Inc., 519 B.R. 581, 584 (Bankr. D.P.R. 2014) (agreeing with DB Capital, but ruling that waiver in prepetition forbearance agreement was enforceable because, after filing for chapter 11, debtor entered into court-approved cash collateral stipulation in which it ratified prepetition loan documents, including forbearance agreement).
Bankruptcy Remoteness and Blocking Directors
As a general rule, corporate formalities and applicable state law must be satisfied in commencing a bankruptcy case. See In re NNN 123 N. Wacker, LLC, 510 B.R. 854 (Bankr. N.D. Ill. 2014) (citing Price v. Gurney, 324 U.S. 100 (1945); In re Gen-Air Plumbing & Remodeling, Inc., 208 B.R. 426 (Bankr. N.D. Ill. 1997)); In re Comscape Telecommunications, Inc., 423 B.R. 816 (Bankr. S.D. Ohio 2010). As a result, while contractual provisions that prohibit a bankruptcy filing may be unenforceable as a matter of public policy, other measures designed to preclude a debtor from filing for bankruptcy may be available.
Lenders, investors, and other parties seeking to prevent or limit the possibility of a bankruptcy filing have attempted to sidestep the public policy invalidating contractual waivers of a debtor’s right to file for bankruptcy protection by eroding or eliminating the debtor’s authority to file for bankruptcy under its governing organizational documents. See, e.g., DB Capital Holdings, LLC v. Aspen HH Ventures, LLC (In re DB Capital Holdings, LLC), 2010 WL 4925811 (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.D.N.Y. 2013); Green Bridge Capital S.A. v. Ira Shapiro (In re FKF Madison Park Group Owner, LLC), 2011 BL 24531 (Bankr. D. Del. Jan. 31, 2011); In re Global Ship Sys. LLC, 391 B.R. 193 (Bankr. S.D. Ga. 2007); In re Kingston Square Associates, 214 B.R. 713 (Bankr. S.D.N.Y. 1997). These types of provisions have not always been enforced, particularly where the organizational documents include an outright prohibition of any bankruptcy filing. See In re Bay Club Partners-472, LLC, 2014 BL 125871 (Bankr. D. Or. May 6, 2014) (refusing to enforce restrictive covenant in debtor limited liability company’s operating agreement, rather than loan agreement; prohibiting bankruptcy filing; and stating that covenant “is no less the maneuver of an ‘astute creditor’ to preclude [Bay Club Partners-472] from availing itself of the protections of the Bankruptcy Code prepetition, and it is unenforceable as such, as a matter of public policy”).
Many of these efforts have been directed toward “bankruptcy remote” special purpose entities (“SPEs”). An SPE is an entity created in connection with a financing or securitization transaction structured to ring fence the SPE’s assets from creditors other than secured creditors or investors (e.g., trust certificate holders) that provide financing or capital to the SPE.
Such an entity is generally designed to be bankruptcy remote to minimize exposure to a voluntary bankruptcy filing by limiting the circumstances under which the SPE’s board or managing members can put the entity into bankruptcy. A common way of achieving this goal is to appoint an “independent” or “blocking” director to the SPE’s governing body.
The organizational documents of an SPE typically will provide that a bankruptcy filing and certain other significant actions must be approved unanimously by the board of directors or other governing body. A director nominated by the lender then has the power to prevent a bankruptcy filing by withholding consent. The documents will further provide that actions requiring unanimity may not be taken if that director’s seat is vacant and that the documents may not be amended without the consent of all directors.
Exposure to involuntary bankruptcy can be limited by specifically restricting the secured and unsecured debt that an SPE can incur, thereby limiting the pool of qualified petitioning creditors for an involuntary bankruptcy petition. Finally, SPEs are typically structured to reduce the risk that the corporate structures of an SPE and related entities are disregarded (e.g., through veil piercing or substantive consolidation) by requiring the SPE to observe corporate formalities.
Recent court rulings have led to significant questions regarding the efficacy of the SPE model as an effective means of achieving bankruptcy remoteness. For example, in In re Gen. Growth Props., Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009), the court denied a motion by secured lenders to dismiss voluntary chapter 11 filings by several SPE subsidiaries of real estate investment trust General Growth Properties, Inc. (“GGP”). The lenders argued, among other things, that the loan agreements with the SPEs provided that an SPE could not file for bankruptcy without the approval of an independent director nominated by the lenders. The lenders also argued that, because the SPEs had no business need to file for bankruptcy and because GGP exercised its right to replace the independent directors less than 30 days before the bankruptcy filings, the SPE’s chapter 11 filings had not been undertaken in good faith.
The bankruptcy court ruled that it was not bad faith to replace the SPEs’ independent directors with new independent directors days before the bankruptcy filings because the new directors had expertise in real estate, commercial mortgage-backed securities, and bankruptcy matters. The court determined that, even though the SPEs had strong cash flows, bankruptcy remote structures, and no debt defaults, the chapter 11 filings had not been made in bad faith. The court found that it could consider the interests of the entire group of affiliated debtors as well as each individual debtor in assessing the legitimacy of the chapter 11 filings.
Among the potential flaws in the bankruptcy remote SPE structure brought to light by General Growth was the requirement under applicable Delaware 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. Thus, an independent director or manager who simply votes to block a bankruptcy filing at the behest of a secured creditor without considering the impact on shareholders could be deemed to have violated its fiduciary duties of care and loyalty. See In re Lake Mich. Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016) (“blocking” member provision in membership agreement of special purpose limited liability company was unenforceable because it did not require member to comply with fiduciary obligations under applicable nonbankruptcy law); see also In re Intervention Energy Holdings, LLC, 2016 BL 181680, *5 (Bankr. D. Del. June 3, 2016) (“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 [by means of a “golden share”] 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.”).
Bad Boy Guarantees
Rapid expansion of the market for commercial mortgage-backed securities (CMBS) has led to an increasing use of “nonrecourse” financing, whereby the lender may look only to its collateral, as distinguished from other assets of the borrower, in seeking repayment of a loan. As a way to enhance recoveries on nonrecourse loans, lenders have in the past relied on “bad boy,” “springing,” or “nonrecourse carveout” guarantees that give a lender some degree of recourse to the borrower should the borrower commit fraud or other “bad acts,” such as converting rents, withholding other payments earmarked for the lender, making intentional misrepresentations, or encumbering the collateral without permission.
Nonrecourse lenders intent upon minimizing opposition to the enforcement of their remedies against the collateral and/or making borrowers more bankruptcy remote have expanded the scope of bad boy guarantees. In doing so, through the guarantees, the lenders impose personal liability on any person controlling the borrower upon the occurrence of events that were not traditionally deemed “bad acts,” such as a bankruptcy filing by (or against) the borrower, the borrower’s opposition to foreclosure, or the borrower’s failure to maintain its status as an SPE.
Courts have generally enforced bad boy guarantees triggered by bankruptcy filings or other equivalent events, such as an assignment for the benefit of creditors or generally not paying debts as they mature. See, e.g., G3-Purves St., LLC v. Thomson Purves, LLC, 101 A.D.3d 37, 41 (N.Y. App. Div. 2012) (“contrary to the guarantors’ contention, the carve-out language in the loan agreement was unambiguous and provided for personal liability for a violation of certain enumerated exceptions, including defined ‘springing recourse events’ ”); Wells Fargo Bank, N.A. v. Daniels, 2011-Ohio-6555 (Ohio Ct. App. 2011) (“the plain language of the guaranty agreements and the related agreements provided that Daniels and Baird would become liable for the entire indebtedness upon the occurrence of certain events, including the borrower filing a petition for bankruptcy,” and that “[t]he agreements did not require the guarantors’ consent to, authorization of, or even knowledge about the filing of the bankruptcy petition in order to trigger their liability”); First National Bank v. Brookhaven Realty Assoc., 637 N.Y.S. 2d 418, 421 (N.Y. App. Div. 1996) (“[t]he appellants are bound by the terms of the contract[,] and enforcement of the bankruptcy default clause is neither inequitable, oppressive, [nor] unconscionable”), appeal dismissed, 88 N.Y.2d 963 (1996); see also CT Inv. Mgmt. Co. v. Carbonell, 2012 BL 8472 (S.D.N.Y. Jan. 11, 2012) (extending comity to Mexican court order staying actions against guarantors based on Mexican debtor’s voluntary bankruptcy filing).
For example, in Bank of America, N.A., et al., v. Lightstone Holdings, LLC, et al., 2011 BL 396859 (N.Y. Sup. Ct. July 14, 2011), the court granted summary judgment against David Lichtenstein and Lightstone Holdings, LLC, finding them liable under bad boy guarantees given in connection with a structured commercial real estate loan secured by the Extended Stay hotel properties. The bad boy acts included a voluntary bankruptcy filing by the borrowers, which triggered recourse liability to the borrowers as well as the guarantors’ personal liability for up to $100 million. The court rejected the guarantors’ arguments that the guarantee violated public policy or was an unenforceable penalty, thereby reaffirming its prior decision in UBS Commercial Mortg. Trust 2007-FLI v. Garrison Special Opportunities Fund L.P., 2010 BL 295421 (N.Y. Sup. Ct. Mar. 8, 2011).
Other courts have also concluded that bad boy guarantee liability triggered by a bankruptcy filing is not unenforceable as a matter of public policy. See, e.g., BayNorth Realty Fund VI, L.P. v. Shoaf, 2010 BL 290453 (Mass. Super. Ct. Oct. 19, 2010) (noting that public policy dictated upholding such guarantees in order to preserve commercial value of loan guarantees and not negatively impact credit availability); see also In re Extended Stay Inc., 418 B.R. 49, 59 (Bankr. S.D.N.Y. 2009) (noting that “public policy arguments relating to the guaranty claims [were] of minimal relevance” where principal liable under bad boy guarantee due to bankruptcy filing by borrower actually authorized the filing), aff’d, Five Mile Capital II SPE LLC v. Cerberus Capital Mgmt. (In re Extended Stay Inc.), 435 B.R. 139 (S.D.N.Y. 2010).
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Jones Day publications should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at our discretion. To request reprint permission for any of our publications, please use our “Contact Us” form, which can be found on our website at www.jonesday.com. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the Firm.