Courts 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. There have been a handful of court rulings addressing this issue in recent years, with mixed outcomes. The U.S. Bankruptcy Court for the District of New Jersey weighed in on this controversial issue in In re 3P Hightstown, LLC, 631 B.R. 205 (Bankr. D.N.J. 2021). The court dismissed a chapter 11 case filed by a Delaware limited liability company (“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 noncontrolling position, had no fiduciary duties.
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,” such as by 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 684â85. 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 creditorânot equity holderâand 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 creditorâ¦.” 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), and In re Pace Industries, LLC, No. 20-10927 (MFW) (Bankr. D. Del. May 5, 2020).
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]â¦, 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 bankruptcyâthe constitutional right to file a bankruptcy by a corporationâthan 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 2019, 3P Equity Capital Inc. (“3PEC”), an affiliate of Delaware LLC 3P Hightstown, LLC (“debtor”), borrowed $420,000 from Progress Direct LLC (“Progress”). The loan was secured by a minority membership interest held by 3PEC in a joint venture known as 3PRC, LLC. In September 2019, 3PEC assigned that membership interest, subject to Progress’s lien, to the debtor.
In December 2019, the debtor raised $500,000 in new capital from an investor group (“4J Group”) in exchange for preferred membership interests. The 4J Group also loaned the debtor $125,000 on a subordinated basis. In July 2020, Hightstown Enterprises, LLC (“HEL”) paid $625,000 to acquire the 4J Group loan as well as its preferred membership interests in the debtor. In September 2020, Progress also sold its secured loan to HEL.
The LLC agreement between the debtor and its members included a provision limiting the ability of the debtor’s management to take certain actions, including filing for bankruptcy:
Notwithstanding anything to the contrary contained in this Agreement, until such time as the Preferred Unreturned Capital Value has been reduced to zero, the Company shall not, and shall not permit any of the Company Subsidiaries to engage in or cause any of the following transactions or take any of the following actions, and the Board shall not permit or cause the Company or any of the Company Subsidiaries to engage in, take, or cause any such action, in each case except with the prior approval of the holders of a majority of the outstanding [preferred membership interests] voting separately as a class: â¦ (xi) the initiation by the Company or any Company Subsidiary of a bankruptcy proceeding (or consent to any involuntary bankruptcy proceeding).
The LLC agreement also included a “limitation of liability” provision stating as follows:
This Agreement is not intended to, and does not, create or impose any fiduciary duty on any Covered Person. Furthermore, each of the Members and the Company hereby waives any and all fiduciary duties that, absent such waiver, may be implied by Applicable Law, and in doing so, acknowledges and agrees that the duties and obligations of each Covered Person to each other and to the Company are only as expressly set forth in this Agreement. The provisions of this Agreement, to the extent that they restrict the duties and liabilities of a Covered Person otherwise existing at law or in equity, are agreed by the Members to replace such other duties and liabilities of such Covered Person.
In April 2021, the debtor filed a chapter 11 petition in the District of New Jersey, where its joint venture real estate holdings were located. HEL moved to dismiss the case, arguing that the debtor lacked the authority to file for bankruptcy under the LLC agreement. The debtor countered that HEL lacked standing to seek dismissal of the case because the 4J Group’s assignment of its loan and preferred membership interests in the debtor failed to comply with the LLC agreement’s notice procedures. The debtor also argued that the LLC agreement provision restricting its ability to file for bankruptcy was invalid as a matter of public policy.
The Bankruptcy Court’s Ruling
Initially, U.S. Bankruptcy Judge Michael B. Kaplan ruled that HEL’s standing to seek dismissal was irrelevant because the court had the authority to dismiss a chapter 11 case “for cause” under section 1112(b) of the Bankruptcy Code on its own initiative.
Next, Judge Kaplan found that the plain language of the LLC agreement prohibited the bankruptcy filing because all preferred capital had not been returned to the preferred membership interest holders and those holders had not approved the chapter 11 filing. Regardless of whether the assignment to HEL was valid, he explained, under the circumstances, the consent of either HEL or its predecessor the 4J Group was required for the bankruptcy filing, yet the debtor obtained neither.
Judge Kaplan rejected the debtor’s public policy argument. Other cases holding that such bankruptcy filing restrictions were unenforceable, he wrote, were factually distinguishable, “and the concerns articulated by courts that have stricken such contractual provisions are not present in this case.” 3P Hightstown, 631 B.R. at 211.
Noting the absence of any Third Circuit precedent, Judge Kaplan looked to Franchise Services, Lexington Hospitality, Intervention Energy, and Pace for guidance. He found Franchise Services to be “strikingly analogous” because it also involved a motion to dismiss filed by an equity holder that was also a creditor (or controlled by one). Like the Fifth Circuit, Judge Kaplan concluded that the blocking provision in the LLC agreement was “not void merely due to [HEL’s] (or the 4J Group’s) status as both an equity holder and a creditor.” Id.
Judge Kaplan found that the case before him was distinguishable from Lexington Hospitality and Intervention Energy. He noted that the lenders in those cases conditioned financing or loan forbearance on being given a “golden share” with which they could block a bankruptcy filing. In this case, Judge Kaplan explained, there was no evidence to suggest that HEL’s contribution, which was substantial and significantly exceeded the amount of its loan, was “merely a ruse to ensure” that the debtor repaid the loan.
According to Judge Kaplan, Pace and other decisions addressing the public policy issue have attempted to balance the constitutional right to file for bankruptcy against the constitutional right to contract and enforce agreements with creditors and other stakeholders. Pace, he wrote, is distinguishable, because it was “bottomed on the narrow specific facts of the caseâ¦, which are dramatically different.” He explained that the debtor in Pace needed to file for bankruptcy to preserve value and protect employees and creditors, and the court accordingly concluded that the bankruptcy case would benefit most stakeholders.
The Pace court’s finding that the blocking provision was void as a matter of public policy, Judge Kaplan noted, was premised on its finding that the majority shareholders owed a fiduciary duty to other shareholders and all creditors because the company was in the “zone of insolvency.” The Pace court, he explained, concluded that the blocking provision allowed the minority shareholder to “violate, or side-step, its fiduciary duty and infringe on the debtor’s constitutional right to file for bankruptcy.” Id.
Judge Kaplan declined to follow this approach for two reasons. First, he noted that the debtor before him was a non-operating investor in a joint venture without any employees, significant creditors, or other stakeholders that would stand to benefit from the bankruptcy. Second, Judge Kaplan had “serious reservations” that HEL, as a noncontrolling minority member, had any fiduciary duties because Delaware law establishes that only managing members of an LLC have such duties, the Delaware LLC Act expressly permits members to contract around even those duties, and, in fact, the limitation of liability provision in the LLC agreement between the debtor and its members did precisely that. “In sum,” Judge Kaplan wrote, “there is no breach of fiduciary duty which renders the provision at issue violative of public policy.” Id. at 214.
Recent court rulings have not resolved the ongoing dispute over the enforceability of blocking provisions, golden shares, and other provisions designed to manage access to bankruptcy protection. 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.