Mixed Signals on Enforcement of Provisions Precluding Bankruptcy Filing Absent Lender's Consent
Courts sometimes disagree over whether provisions in a borrower's organizational documents designed to prevent the borrower from filing for bankruptcy are enforceable as a matter of federal public policy or applicable state law. Two recent rulings addressing this issue illustrate the divide. In Franchise Services of North America, Inc. v. Macquarie Capital (USA), Inc. (In re Franchise Services of North America, Inc.), 891 F.3d 198 (5th Cir. 2018), the U.S. Court of Appeals for the Fifth Circuit affirmed a bankruptcy court order dismissing a chapter 11 case filed by a corporation without obtaining—as required by its corporate charter—the consent of a preferred shareholder that was also controlled by a creditor of the corporation. The Fifth Circuit ruled that federal law does not strip a bona fide equity holder of its preemptive voting rights merely because it is also a creditor. It also held that the preferred shareholder-creditor was not a controlling shareholder under applicable state law such that it had a fiduciary duty to the corporation that would impact any decision to approve or prevent a bankruptcy filing.
More recently, in In re Insight Terminal Solutions, LLC, 2019 WL 4640773 (Bankr. W.D. Ky. Sept. 23, 2019), the U.S. Bankruptcy Court for the Western District of Kentucky denied a motion to dismiss the chapter 11 cases of two affiliated limited liability companies that, at the behest of their secured lender, amended their organizational documents to provide that the companies could not file for bankruptcy without the consent of all holders of one of the company's membership units, which had been pledged to secure the loan. According to the court, this attempt by the lender to circumvent the bankruptcy laws and federal public policy was ineffective.
Bankruptcy Risk Management by Lenders
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 have involved attempts to structure a loan transaction to maximize the likelihood 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.
Depending on the jurisdiction involved and the particular circumstances, including the terms of the relevant documents, these mechanisms may or may not be enforceable.
Bankruptcy/Automatic Stay Waivers. 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) (the agreement not to file for bankruptcy for a 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 A. Hirsch Realty, LLC, 583 B.R. 583 (Bankr. D. Mass. 2018) (a prepetition bankruptcy waiver of the automatic stay contained in the debtor's prior confirmed chapter 11 plan is not per se enforceable; although the prepetition waiver is "cause" for stay relief, the court must conduct a fact-intensive examination to determine whether the waiver should be enforced); In re Bryan Road, LLC, 382 B.R. 844, 849 (Bankr. S.D. Fla. 2008) (setting forth factors for the court to consider in deciding whether to enforce a stay waiver agreement, including: (i) the sophistication of the waiving party; (ii) the consideration for the waiver, including the creditor's risk and the length of time covered by the waiver; (iii) whether other parties are affected; and (iv) the feasibility of the debtor's plan); In re Frye, 320 B.R. 786 (Bankr. D. Vt. 2005) (a prepetition waiver is neither per se unenforceable nor enforceable; a waiver would be enforced unless the debtor could show sufficient equity in the property, a sufficient likelihood of an effective reorganization, or sufficient prejudice to other creditors); accord SummitBridge Nat'l Investments VI, v. Orchard Hills Baptist Church, Inc. (In re Orchard Hills Baptist Church, Inc.), 2019 WL 5586638 (Bankr. N.D. Ga. Oct. 28, 2019). But see In re Jeff Benfield Nursery, Inc., 565 B.R. 603 (Bankr. W.D.N.C. 2017) (concluding that such provisions, which effectively render the automatic stay meaningless, are unenforceable as a matter of public policy and noting that, even if they were not, the court would not enforce the waiver under the circumstances because the debtor did not receive significant consideration in return for it, as might be the case in a more specific forbearance agreement).
Courts have typically enforced prepetition stay waivers as part of forbearance agreements, as distinguished from original loan documentation, or as agreements that have been approved by courts in previous bankruptcy cases. See Bryan Road, 382 B.R. at 848; accord 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 they are part of a confirmed plan or stipulation resolving an earlier motion for relief but otherwise "appear to conflict with the policies and purposes of the Bankruptcy Code, and should not be enforced"); In re Atrium High Point Ltd. P'ship, 189 B.R. 599 (Bankr. M.D.N.C. 1995) (enforcing the automatic stay waiver in a plan of reorganization confirmed in a previous chapter 11 case).
Bankruptcy Remoteness, Blocking Provisions, and Golden Shares. As a 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 Lexington Hospitality Group, 577 B.R. 676 (Bankr. E.D. Ky. 2017) (where an LLC debtor's operating agreement provided for a lender representative to be a 50% member of the debtor until the loan was repaid and included various restrictions on the debtor's ability to file for bankruptcy while the loan was outstanding, the bankruptcy filing restrictions acted as an absolute bar to a bankruptcy filing, which is void as against public policy); In re Bay Club Partners-472, LLC, 2014 BL 125871 (Bankr. D. Or. May 6, 2014) (refusing to enforce a restrictive covenant in a debtor LLC's operating agreement prohibiting a bankruptcy filing and stating that the covenant "is no less the maneuver of an 'astute creditor' to preclude [the LLC] 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.
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 a real estate investment trust. 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 the trust 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 General Growth 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 is 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 his or her fiduciary duties of care and loyalty. See In re Lake Mich. Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016) (a "blocking" member provision in the membership agreement of a special purpose limited liability company was unenforceable because it did not require the member to comply with its fiduciary obligations under applicable non-bankruptcy law).
Courts disagree as to the enforceability of blocking provisions and, in particular, "golden shares" that, as the term is used in a bankruptcy context, give the holder the right to preempt a bankruptcy filing. Compare In re Lexington Hospitality, 577 B.R. at 684–85 (denying a motion to dismiss a bankruptcy case filed by a wholly owned entity of a creditor that held a golden share/blocking provision where the entity was not truly independent); In re Intervention Energy Holdings, LLC, 553 B.R. 258, 265 (Bankr. D. Del. 2016) (ruling that a provision in a limited liability company's governance document, "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") with Squire Court Partners v. CenterLine Credit Enhanced Partners (In re Squire Court Partners), 574 B.R. 701 (E.D. Ark. 2017) (where a partnership agreement required the unanimous consent of the partners before the limited partnership could "file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy," a bankruptcy filing by the managing partner without the consent of the other partners was properly dismissed); see also In re Tara Retail Group, LLC, 2017 WL 1788428 (Bankr. N.D. W. Va. May 4, 2017) (even though a creditor held a golden share or blocking provision, it ratified the debtor's bankruptcy filing by its silence), appeal dismissed, 2017 WL 2837015 (N.D. W. Va. June 30, 2017).
Recent Court Rulings
Franchise Services. In Franchise Services, a bank invested $15 million in Franchise Services of North America ("FSNA") as part of a transaction to purchase an FSNA competitor in exchange for 100% of FSNA's convertible preferred stock. The preferred stock was convertible to slightly less than 50% of FSNA's common stock. FSNA was also obligated to pay certain investment fees to the bank's parent in connection with the transaction. As a condition to the investment, FSNA amended its certificate of incorporation to provide that FSNA could not "effect any Liquidation Event" (defined to include a bankruptcy filing) without the approval of the holders of a majority of both its preferred and common stock.
FSNA filed for chapter 11 protection in 2017 without obtaining the consent of a majority of its preferred and common stockholders. FSNA still owed certain amounts to the bank's parent at time of the bankruptcy filing. The bank moved to dismiss the petition as having been filed without proper authorization. The bankruptcy court found that the bank itself was an owner, rather than a creditor, of FSNA and ruled that the shareholder consent provision was not contrary to federal bankruptcy policy. The court opted to leave to Delaware state courts the determination as to whether the provision violated Delaware law. It accordingly dismissed FSNA's chapter 11 case.
On direct appeal, the Fifth Circuit affirmed. It rejected FSNA's argument that, even if Delaware law authorized the corporate charter provision at issue, federal law forbids such a provision due to the public policy against waiving bankruptcy protections. The court wrote that "[t]here is no prohibition in federal bankruptcy law against granting a preferred shareholder the right to prevent a voluntary bankruptcy filing just because the shareholder also happens to be [controlled by] an unsecured creditor…."
The Fifth Circuit also rejected FSNA's contention that, even if a shareholder-creditor can hold a bankruptcy veto right, such a right "remains void in the absence of a concomitant fiduciary duty." No statute or binding case law, the court explained, "licenses this court to ignore corporate foundational documents, deprive a bona fide shareholder of its voting rights, and reallocate corporate authority to file for bankruptcy just because the shareholder also happens to be an unsecured creditor." In the absence of evidence showing that the bank was a controlling minority shareholder, the Fifth Circuit found that the bank did not have fiduciary duties to FSNA. Even if it were a controlling shareholder, the Fifth Circuit noted, the proper remedy for a breach of fiduciary duty "is not to allow a corporation to disregard its charter and declare bankruptcy without shareholder consent," but to seek redress under state law.
Insight. In 2018, Autumn Wind Lending, LLC ("Autumn Wind") provided up to $6.8 million in financing under a term loan facility to Delaware limited liability company Insight Terminal Solutions, LLC ("ITS"). The original maturity date of the loan was December 31, 2018. The loan was guaranteed by an ITS affiliate holding all of the outstanding ITS membership units and secured by a lien on substantially all of the assets of ITS and the guarantor. The pledged collateral included the ITS membership units held by the guarantor as well as certain warrants for ITS membership units.
In connection with an extension of the maturity date of the loan to June 30, 2019, Autumn Wind amended the loan agreement to include a bankruptcy rights waiver. It provided that: (i) if the loan was not paid in full on or before June 30, 2019 and Autumn Wind refused to grant an additional extension of the maturity date, the guarantor agreed to relinquish its rights to the pledged ITS membership units; and (ii) ITS and the guarantor agreed to amend their respective organizational documents so that neither would be permitted to file for bankruptcy protection unless they first obtained the prior written consent of all holders of ITS membership units and any party holding warrants for such units. Both ITS and the guarantor later amended their operating agreements to include the bankruptcy rights waiver.
On July 1, 2019, ITS and the guarantor defaulted on the loan. The following day, Autumn Wind notified ITS and the guarantor that it intended to retain the pledged ITS membership units and that, in accordance with the Uniform Commercial Code (the "UCC"), they had 20 days to object to the proposed retention. After further amending their operating agreements to authorize a bankruptcy filing and adopting resolutions authorizing such a filing, ITS and the guarantor (collectively, the "debtors") filed for chapter 11 protection in the Western District of Kentucky on July 17, 2019—prior to the expiration of the 20-day period.
Autumn Wind moved to dismiss the chapter 11 cases, arguing that, in accordance with the bankruptcy rights waiver, the debtors lacked the authority to file for bankruptcy. According to Autumn Wind, when the debtors defaulted on the loan, the guarantor's right to exercise voting and/or consensual rights and powers over the ITS membership units ceased immediately and such rights became vested solely and exclusively in Autumn Wind. Moreover, Autumn Wind contended that, in its capacity as a holder of warrants for ITS membership units, Autumn Wind's consent was required for any bankruptcy filings by the debtors.
The bankruptcy court denied the motion to dismiss. Initially, the court found that, by amending their operating agreements in July 2019 and adopting resolutions authorizing a bankruptcy filing, the debtors had authority under Delaware law to file for chapter 11 protection.
The debtors argued that the ITS membership units were never transferred to Autumn Wind because it did comply with the UCC's strict foreclosure requirements. The court acknowledged that "this is a compelling argument." However, the court noted that it need not address this argument because "there is a more compelling reason" to deny the motion to dismiss—specifically, the bankruptcy rights waiver violated federal public policy.
The court explained as follows:
Autumn Wind's primary witness testified that it was well aware that a contractual provision limiting a debtor's right to seek relief under the Bankruptcy Code was legally unenforceable as against public policy. It was for this very reason that Autumn Wind included terms in the waiver and amendment that if Debtors did not achieve additional financing during the 3-1/2 month period they provided, then the agreement would provide a prohibition on filing for bankruptcy under this amendment. On July 1, 2019, the collateral would be turned over to Autumn Wind. Autumn Wind believed that by using this provision, they would avoid the public policy issue. . . . However, the terms of the surrender of the collateral were not fully consummated as there was no completion of the strict foreclosure process. Furthermore, the attempt to circumvent the bankruptcy laws and public policy by "circuitry of arrangement," were ineffective. Autumn Wind tried to get around this argument by making itself an equity holder, however, the process to achieve this was not completed. Autumn Wind did not become an equity holder, nor did they become the owner of the collateral through the strict foreclosure process. Furthermore, attempts to limit the Debtors' access to the bankruptcy process were against public policy and invalid.
Recent court rulings have done little to resolve the ongoing dispute over the enforceability of blocking provisions, golden shares, and other provisions designed to manage access to bankruptcy protection.
Because it involved a minority shareholder (whose parent company was an unsecured creditor) without any fiduciary obligations, Franchise Services did not involve many of the more difficult questions posed by other cases involving these issues. Even so, the Fifth Circuit's conclusion that a shareholder cannot be stripped of its bankruptcy preemption rights merely because it is also controlled a creditor is noteworthy, especially for private equity sponsors and other investors who take both equity and debt positions in a portfolio company.
The bankruptcy court in Insight arguably adopted a more categorical approach, invalidating a blocking provision outright as a matter of federal public policy. Given this rationale, the court never considered whether any fiduciary duties potentially borne by the lender as the sole holder of a debtor's membership units should have had any bearing on the lender's decision to permit or prevent a bankruptcy filing.
Finally, Franchise Services, Insight and other relevant decisions reinforce the importance of knowing what approach the courts have endorsed in any likely bankruptcy venue.
A version of this article was published in Lexis Practice Advisor and Law360. It has been reprinted here with permission.
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