Chapter 11 Filing Without Consent of Independent Director Dismissed as Unauthorized
Courts disagree over whether provisions in a borrower's organizational documents or loan agreements designed to restrict or prevent the borrower from filing for bankruptcy are enforceable as a matter of federal public policy or applicable non-bankruptcy law. There have been a handful of court rulings addressing this issue in recent years, with mixed outcomes. The U.S. Bankruptcy Court for the Northern District of Illinois weighed in on the debate in In re 301 W N. Ave., LLC, 666 B.R. 583 (Bankr. N.D. Ill. 2025), appeal filed, No. 24 B 2741 (Bankr. N.D. Ill. Jan. 17, 2025) ("301 West North"). The bankruptcy court granted a lender's motion to dismiss a chapter 11 filing by a special purpose limited liability company ("LLC") because an independent director appointed by an agent of the lender did not consent to the filing, as was required in the loan agreement and the debtor's LLC agreement. According to the court, the requirement for the director's consent to a bankruptcy filing violated neither federal public policy nor applicable non-bankruptcy law because the director had explicit fiduciary duties to the debtor and its creditors.
Bankruptcy Risk Management by Lenders
Astute lenders are always looking for ways to minimize risk 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." Strategies employed by lenders include implementing a "blocking director" organizational structure or issuing "golden shares" that, as the term is used in a bankruptcy context, give the holder the right to preempt a bankruptcy filing. Depending on the jurisdiction involved and the particular circumstances, including the terms of the relevant documents, these mechanisms may or may not be enforceable.
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 Comscape Telecommunications, Inc., 423 B.R. 816 (Bankr. S.D. Ohio 2010); In re Gen-Air Plumbing & Remodeling, Inc., 208 B.R. 426 (Bankr. N.D. Ill. 1997). 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., 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); In re FKF Madison Park Group Owner, LLC, 2011 WL 350306 (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 WL 1796688 (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 (sometimes referred to as special purpose vehicles) ("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 shareholder the right to preempt a bankruptcy filing. For example, in Lexington Hospitality, the bankruptcy court denied a motion to dismiss a bankruptcy case filed by an entity wholly owned by a creditor that held a golden share/blocking provision because the court concluded that the entity was not truly independent. 577 B.R. at 684–85. In addition, in In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016), the court ruled 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.
Id. at 265; 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).
By contrast, in In re Squire Court Partners, 574 B.R. 701, 704 (E.D. Ark. 2017), the court ruled that, 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," the bankruptcy court properly dismissed a bankruptcy filing by the managing partner without the consent of the other partners.
One of the seminal cases addressing this issue is In re Franchise Services of North America, Inc., 891 F.3d 198 (5th Cir. 2018). In Franchise Services, as a condition to an investment by a majority preferred stockholder that was controlled by one of the debtor's creditors, the debtor amended its certificate of incorporation to provide that it 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. The U.S. Court of Appeals for the Fifth Circuit ruled 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 …." Id. at 208. The Fifth Circuit rejected the argument 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." Id. at 209.
Other notable cases include In re Insight Terminal Solutions, LLC, 2019 WL 4640773 (Bankr. W.D. Ky. Sept. 23, 2019); In re Pace Industries, LLC, No. 20-10927 (MFW) (Bankr. D. Del. May 5, 2020); and In re 3P Hightstown, LLC, 631 B.R. 205 (Bankr. D.N.J. 2021).
In Insight, a lender, as a condition to extending the maturity date of a loan to a Delaware LLC, demanded that the borrower and its guarantor amend their operating agreements so that neither would be permitted to file for bankruptcy unless they first obtained the prior written consent of all holders of the membership units in the borrower that had been pledged to secure the loan. After defaulting on the loan, but before the lender could foreclose on the pledged membership units, the borrower and the guarantor again amended their operating agreements to remove the lender consent provision and filed for chapter 11 protection. The lender moved to dismiss. The bankruptcy court denied the motion, finding that the debtors had authority under Delaware law to file for bankruptcy in accordance with their amended operating agreements, and ruling that "attempts to limit the Debtors' access to the bankruptcy process were against public policy and invalid." Insight, 2019 WL 4640773, at *3.
In Pace, a Delaware corporation amended its certificate of incorporation in connection with a pre-bankruptcy debt-for-equity swap to provide that any voluntary bankruptcy filing by the company or its affiliates "shall require the written consent or affirmative vote of the holders of a majority in interest of the [new preferred stock] …, and any such action taken without such consent or vote shall be null and void ab initio, and of no force or effect." The company and certain affiliates later filed prepackaged chapter 11 cases, without the consent of a majority of the preferred stockholders, who moved to dismiss the bankruptcy filings as unauthorized.
The stockholders acknowledged cases finding that shareholder bankruptcy consent rights violate public policy if exercised by a shareholder that is also a creditor holding a "golden share," but argued that they were preferred stockholders only, not creditors. They also argued that, consistent with Franchise Services, a minority shareholder (which they all were) is not a controlling shareholder with fiduciary duties.
Ruling from the bench, the bankruptcy court denied the motion to dismiss, holding as a matter of first impression that, on these facts, "a blocking right by a shareholder who is not a creditor is void as contrary to federal public policy that favors the constitutional right to file bankruptcy." Pace, No. 20-10927 (MFW) (Bankr. D. Del. May 6, 2020), Transcript of Telephonic Hearing at 38 [Doc. No. 147].
The Pace court "respectfully declined" to follow Franchise Services, noting that it saw "no reason to conclude that a minority shareholder has any more right to block a bankruptcy—the constitutional right to file a bankruptcy by a corporation—than a creditor does." Id. at 40. Moreover, it explained, contrary to the Fifth Circuit's interpretation of Delaware law in Franchise Services, under Delaware law, "a blocking right, such as exercised in the circumstances of this case, would create a fiduciary duty on the part of the shareholder; a fiduciary duty that, with the debtor in the zone of insolvency, is owed not only to other shareholders, but also to all creditors." Id. at 41.
Other factors combined with the blocking right, the court noted (i.e., the debtors were in the zone of insolvency, lacked liquidity, and could not pay their debts as they matured without debtor-in-possession financing, coupled with severe operational disruption due to the pandemic), supported a finding that the preferred shareholders' blocking right created a fiduciary duty.
In 3P Hightstown, the bankruptcy court dismissed a chapter 11 case filed by a Delaware LLC because the LLC agreement precluded a bankruptcy filing without the consent of a holder of preferred membership interests whose capital contributions had not been repaid. According to the court, the bankruptcy blocking provision was not void as a matter of public policy because, under both Delaware law and the express terms of the LLC agreement, the holder of the preferred membership interests, which held a non-controlling position, had no fiduciary duties. "In sum," the court wrote, "there is no breach of fiduciary duty which renders the provision at issue violative of public policy." 3P Hightstown, 631 B.R. at 214.
301 West North
301 West North Avenue, LLC (the "debtor") is a Delaware LLC that owns a mixed-use high-rise building in Chicago (the "property"). The debtor has two members (the "Members") and is managed by MK Manager Corp. ("MK").
In 2020, the predecessor-in-interest of BDS III Mortgage Capital G, LLC ("BDS") loaned $26 million to the debtor secured by a mortgage on the property. The loan agreement required the debtor to be a bankruptcy remote entity. It also provided that the debtor appoint an "independent director" or manager acceptable to BDS. Pursuant to a "Staffing Agreement" with CT Corp. Staffing, Inc. ("CTCS"), CTCS designated an independent manager (the "Director") for the debtor who served in that role for more than 500 corporate entities.
The Staffing Agreement provided that the debtor's governing body, prior to making a decision in any matter before it, was required to give the Director reasonable advance notice and an opportunity to investigate the proposed action. The Staffing Agreement had an initial term of one-year, subject to automatic renewal unless either the debtor or CTCS gave 30 days' prior written notice of termination. The Staffing Agreement also obligated the debtor to indemnify CTCS and the Director for any liability arising from services provided under the agreement or any breach of the agreement's representations and warranties, other than liabilities arising solely from the willful misconduct of either CTCS or the Director. Finally, the Staffing Agreement included a covenant that the debtor would not sue CTCS or the Director for anything other than willful misconduct.
The Loan Agreement between the debtor and BDS provided that: (i) the unanimous consent of all of the debtor's members and the Director was required for debtor to file for bankruptcy; (ii) the debtor's organizational documents had to provide that the debtor at all times must have an independent director "reasonably satisfactory" to BDS; (iii) the organizational documents must provide that the debtor's board cannot not take any action requiring the unanimous consent of the board without a Director; and (iv) any resignation, removal, or replacement of the Director be valid only upon advance notice to BDS, and only if supported by evidence that the replacement Director satisfied the terms of the debtor's organizational documents.
The debtor's LLC Agreement provided in relevant part that: (i) the debtor had to remain a "manager managed" single-purpose LLC with one "independent manager" (i.e., the Director) so long as the debt to BDS remained unpaid; and (ii) the debtor could not make "major decisions," including filing for bankruptcy, without the unanimous consent of all managers, including the independent manager. It also included the following provisions regarding the fiduciary duties of the independent manager:
To the fullest extent permitted by applicable law … the Independent Manager shall consider only the interests of the Constituent Members and Company (including Company's respective creditors) in acting or otherwise voting on the matters provided for in this Agreement (which such fiduciary duties to the Constituent Members and Company (including Company's respective creditors), in each case, shall be deemed to apply solely to the extent of their respective economic interests in Company exclusive of (x) all other interests (including, without limitation, all other interests of the Constituent Members), (y) the interests of other affiliates of the Constituent Members and Company and (z) the interests of any group of affiliates of which the Constituent Members or Company is a part).
Except as provided [in this Agreement], the Independent Manager shall, in exercising their rights and performing their duties under this Agreement, 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.
The Director executed the LLC Agreement as "Independent Manager/Special Member." However, when the Members signed the agreement, the Director's signature page was omitted and the agreement was signed instead by MK.
The BDS loan matured in October 2023, at which time the debtor defaulted by failing to pay the outstanding debt in full. BDS then commenced a foreclosure proceeding, which was stayed on February 27, 2024, when the debtor filed for chapter 11 protection in the Northern District of Illinois. The petition was signed by a representative of MK, who declared that he was authorized to file the petition on the debtor's behalf. The MK representative later stated that he was not aware that the Director's consent was required for the filing.
In April 2024, the Director submitted a resignation notice to the debtor, but backdated the notice to August 31, 2022, the last date that the debtor's paid CTCS under the Staffing Agreement. The debtor did not provide BDS with any notice of the Director's resignation, as was required under the LLC Agreement.
BDS submitted a claim in the amount of approximately $30.4 million secured by a mortgage on the property, which the debtor valued at $19.4 million.
In May 2024, the debtor proposed a chapter 11 plan under which BDS would be paid either $17.8 million within 110 days of the plan's effective date or approximately $101,000 per month for 30 years if BDS elected under section 1111(b) of the Bankruptcy Code to have its claim treated as fully secured.
In July 2024, BDS, arguing that the debtor lacked the proper authority to file for bankruptcy, moved to dismiss the chapter 11 case and to bar the debtor from refiling.
The Bankruptcy Court's Ruling
The bankruptcy court granted the motion to dismiss the debtor's chapter 11 case, but declined to impose a ban on a future bankruptcy filing.
U.S. Bankruptcy Judge David D. Cleary explained that, pursuant to section 1112(b) of the Bankruptcy Code, a bankruptcy court "shall" dismiss a chapter 11 case for "cause," which has construed to include lack of corporate authority to file for bankruptcy.
Judge Cleary concluded that the debtor was not authorized to file for chapter 11 protection because the LLC Agreement required the Director's consent for a bankruptcy filing and no such consent was given, nor was the Director even consulted before the filing. Thus, the burden shifted to the debtor to rebut the evidence that MK lacked authority to file a chapter 11 petition on the debtor's behalf.
The bankruptcy court rejected the debtor's argument that: (i) MK believed that the Director had resigned before filing the chapter 11 petition, such that the Director's consent was not required; (ii) the Director's resignation constituted acquiescence to the bankruptcy filing; and (iii) the Director ratified the bankruptcy filing.
According to Judge Cleary, the Director resigned in April 2024—two months after the bankruptcy filing—even though she backdated her resignation letter to August 2022, and MK's testimony concerning the Director's resignation was not credible. In addition, he explained, the Director did not acquiesce to the bankruptcy filing because the evidence demonstrated that she did not learn of the filing until April 2024, shortly after which she resigned, and therefore lacked full knowledge of the underlying facts (which is required to establish acquiescence).
Moreover, Judge Cleary noted, the record reflected that the Director consistently repudiated the bankruptcy filing. 301 West North, 666 B.R. at 596 (citation omitted). Finally, the bankruptcy court found that the Director neither expressly nor impliedly ratified the debtor's chapter 11 filing after the fact. Instead, the Director's conduct suggested that she wished to dissociate herself from the debtor as quickly as possible once she learned that it had filed for bankruptcy.
Next, the bankruptcy court ruled that the debtor's organizational documents did not impermissibly restrict its right to file for bankruptcy relief. Judge Cleary acknowledged that provisions in corporate organizational documents that restrict a company's ability to file for bankruptcy or impede its ability to exercise fiduciary duties in evaluating a potential filing are against public policy. However, he explained, provisions that put an independent manager on the board of an LLC, and require that manger to "participate" in certain corporate actions, such as a bankruptcy filing, "are not presumptively void." Id. at 598 (citing Lake Michigan, 547 B.R. at 913).
Compared to other cases in which bankruptcy filing restrictions have been invalidated, the bankruptcy court emphasized, the saving grace in the case before it on public policy grounds was the existence of fiduciary duties in the LLC Agreement requiring the Director to consider the interests of the debtor and its creditors. Judge Cleary rejected the debtor's argument that, because the LLC Agreement required that the Director remain in place until the loan was repaid and provided that the Director could not resign without first giving notice to BDS and its designation of a replacement, "there is nothing independent about [the Director] as she served solely for the benefit of [BDS]." Id. at 600. According to the bankruptcy court, such provisions were logical and did "not lead inexorably to the conclusion that the [Director] is not subject to director fiduciary duties affecting the ability to file for bankruptcy protection." Id.
The court also rejected the debtor's argument that limiting the "interests" that the Director had to consider to the debtor's "economic interests" allowed her to avoid liability for any breach of fiduciary duty. Judge Cleary wrote that "it is entirely appropriate for an independent manager to consider a debtor's economic interest in determining whether it will authorize the filing of a bankruptcy petition." Id. He also noted that the inquiry should be whether an independent manager (such as the Director) has fiduciary duties to the debtor and its creditors, rather than the debtor's members, because the elimination of duties to LLC members is permitted under Delaware law and cannot be interpreted to contravene public policy. Id.
In addition, the bankruptcy court rejected the argument that, because the Staffing Agreement indemnified CTCS and the Director and included a covenant not to sue, except for actions amounting to willful misconduct, the already limited fiduciary duties were rendered "completely barren" and violated Delaware law. The key document, Judge Cleary explained, was the LLC Agreement, rather than the Staffing Agreement, which was merely a contract between the debtor and CTCS. "[I]n compliance with Delaware law," he wrote, the LLC Agreement did not permit indemnification if the Director "acted in bad faith or engaged in willful misconduct." Id. at 601.
The bankruptcy court declined to issue a ban on future bankruptcy filings by the debtor. According to the court, "[i]f a bar to refiling were imposed, it would effectively prohibit the Debtor from deciding—properly, in compliance with the LLC Agreement—whether or not it should file for relief under the Bankruptcy Code." Id.
Finally, the court rejected the debtor's argument that dismissal of the chapter 11 case would not be in the best interests of creditors and the estate. Judge Clearly explained that this assertion is irrelevant because a bankruptcy court is obligated to dismiss a case if it was filed without the required corporate authority. Id.
Outlook
The debtor appealed the bankruptcy court's decision on January 17, 2025. As of the writing of this article, the appeal remains pending before the U.S. District Court for the Northern District of Illinois. See 301 W North Avenue, LLC v. BDS III Mortgage Capital G, LLC, No. 25-00568 (N.D. Ill. Jan. 17, 2025).
Recent court rulings have not resolved the ongoing dispute over the enforceability of blocking provisions, golden shares, and other provisions (such as the appointment of independent directors by lenders) designed to manage access to bankruptcy protection. However, 301 West North and other similar rulings, including Hightstown, Pace, Franchise Services, and Insight, indicate that the validity of such provisions may hinge on whether the holder of a blocking right has fiduciary duties as a matter of law or contract, in which case the courts have expressed heightened public policy concerns. More generally, these and other relevant decisions reinforce the importance of knowing what approach the courts have endorsed in any likely bankruptcy venue. Given the trillions of dollars of securities issued in connection with SPEs, the enforceability of such provisions in various venues may be economically significant.
The independent manager/director framework highlighted by 301 West North is emblematic of the significant proliferation and popularity of that structure in recent SPE lending transactions.
