Lenders should plan for real estate owner bankruptcies despite having a non-recourse carveout guaranty triggered by the owner’s bankruptcy filing.
This is the fifth in a series of alerts on insolvency topics affecting real estate. In this alert, we evaluate whether bankruptcy blockers in a debtor’s governance documents are likely to deter bankruptcies, and the likelihood of success of a motion to dismiss the bankruptcy case based on such blockers. We conclude that debtors file for bankruptcy despite bankruptcy blockers, that courts void them as against public policy, and that lenders may be better off pursuing other exit strategies.
A recent oral ruling by Delaware U.S. Bankruptcy Court Judge Mary F. Walrath highlights why lenders and other stakeholders should not assume that bankruptcy blockers in governance documents will prevent bankruptcies; instead, lenders and other stakeholders should recognize that bankruptcy blockers may be unenforceable as against public policy and should plan accordingly. In the wake of the COVID-19 financial crisis, assessing the likelihood of a borrower bankruptcy filing is critical for lenders, as is determining how best to respond. As the cases discussed below caution, dismissal motions based on bankruptcy blockers often fail. In some cases, lenders may be better served considering alternatives aimed at accelerating favorable collateral disposition.
A principle aspect of federal law is that a person or entity cannot bargain away the right to file for bankruptcy, and any agreement to do so is void as a matter of public policy. But for as long as there have been bankruptcy laws in the United States, creditors have engineered ways to bar borrower bankruptcies. Courts declared early efforts (referred to as “circuity of arrangement”) void as a matter of federal public policy, with one court reasoning that “[i]t would be vain to enact a bankruptcy law with all its elaborate machinery for settlement of the estates of bankrupt debtors, which could so easily [i.e., by contract] be rendered of no effect.”1
In contrast, responsible corporate governance documents should spell out the requirements (e.g., votes) needed to file for bankruptcy. Indeed, an important element to successful structured finance is the requirement that an independent director with fiduciary duties approves voluntary bankruptcy filings. Courts usually honor these types of governance provisions.2
Where these two competing interests clash, bankruptcy courts have consistently voided bankruptcy-blocking provisions that violate federal public policy, despite the guise of routine corporate governance documentation.
A modern decision addressing the clash is In re Lake Michigan Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016). There, the debtor owned and operated real property as a seasonal resort in Coloma, Michigan. In connection with forbearance and workout efforts, the mortgage lender insisted that it be admitted to the borrower’s limited liability company as a “special member,” with the right to veto “Major Actions,” including the borrower’s voluntary bankruptcy, but without having any fiduciary duties. Subsequently, the loan defaulted; the borrower filed for chapter 11, and the lender moved to dismiss based on its refusal to approve the filing. Refusing to elevate form over substance, the bankruptcy court found that the “structure undoubtedly was negotiated by [the lender] to ensure that the Property was not to be administered in a bankruptcy.” The death knell, however, was the fact that the lender was not a genuine member, and instead a creditor without any fiduciary duties to the debtor or its creditors, rendering the blocker provision void as a matter of Michigan and federal public policy. As such, the court denied the motion to dismiss and permitted the debtor to pursue its reorganization efforts.
The facts of In re Intervention Energy Holdings LLC, 553 B.R. 258 (Bankr. D. Del. 2016), are substantively similar. In connection with forbearance and workout efforts, the borrower, engaged in oil and gas exploration and production, acceded to its lender’s demand that it issue one common unit to the lender and modify its operating agreement to require the consent of all common unit owners prior to a voluntary bankruptcy filing. Eventually, the borrower filed for chapter 11 and the lender moved to dismiss the case based on the borrower’s failure to obtain unanimous member consent. The bankruptcy court reasoned that “to characterize the Consent Provision here as anything but an absolute waiver by the LLC of its right to seek federal bankruptcy relief would directly contradict the unequivocal intention of [the lender] to reserve for itself the decision of whether the LLC should seek federal bankruptcy relief.” Finding the provision “void as contrary to public policy,” the bankruptcy court declined to dismiss the case.
A recent oral ruling extends the holding of Intervention Energy Holdings to minority shareholders. In In re Pace Industries LLC, No. 20-10927 (Bankr. D. Del. May 5, 2020), the bankruptcy court held that “a minority shareholder has [no] more right to block a bankruptcy . . . than a creditor does.” In declining to follow the Fifth Circuit’s interpretation of Delaware state law, Judge Walrath concluded that a blocking right could create a fiduciary duty on the part of a minority shareholder. It appears the Pace court declined to dismiss the case, in part, because the minority shareholder had not considered the rights of others in moving to dismiss.
Alternatives to the lender taking voting-control equity have not met with much success either. For example, in In re Bay Club Partners-472 LLC, 2014 WL 1796688 (Bankr. D. Or. 2014), the lender insisted that the borrower’s operating agreement bar the borrower from filing for bankruptcy, regardless of membership vote. Characterizing the lender’s strategy as a “cleverly insidious” maneuver to preclude the borrower from filing for bankruptcy, the bankruptcy court held the bankruptcy waiver unenforceable as a matter of public policy, denying the lender’s motion to dismiss.
Planning and Exploring Options
Bankruptcy courts have refused to enforce governance documents completely banning a company’s bankruptcy filing. “Blocking” or “golden share” provisions in governance documents that were, as a matter of fact, required by the company’s lender are especially problematic. Lenders engaged in forbearance discussions should carefully consider the parameters of bankruptcy limitation requirements. And lenders seeking to have their borrowers’ bankruptcy cases dismissed for failure to comply with governance requirements should consider the likelihood of success, as well as how such motions, if denied, will potentially affect the balance of the proceedings. Similarly, prospective equity holders seeking to control an entity’s bankruptcy decisions through the acquisition of bankruptcy blocking or consent rights should consider carefully the implications and enforceability of such rights prior to purchasing interests in the entity.
For more information, please reach out to your regular Pillsbury contact or the authors of this client alert.
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1 Fed. Nat’l Bank v. Koppel, 253 Mass. 157, 159 (Mass. 1925); see also Nat’l Bank of Newport v. Nat’l Cnty. Bank, 225 U.S. 178, 184 (1912) (prohibiting parties from contracting around bankruptcy laws).
2 The enforceability of governance provisions requiring (a) genuine equity holders to agree on minimum standards (though not a total ban) for filing the bankruptcy, or (b) an independent director with fiduciary duties to approve the bankruptcy filing, is outside the scope of this alert.