Delaware Bankruptcy Court Refuses to Dismiss Chapter 11 Case Despite Existence of Secured Lender’s “Golden Share” in Debtor’s Delaware LLC Agreement: Could Bankruptcy-Remote Structures Be at Risk?
By Paul Hastings Professional
Earlier this month, the Delaware bankruptcy court denied a secured lender’s motion to dismiss a chapter 11 case that had been commenced without the unanimous consent of all unitholders, as required under the debtor’s LLC operating agreement.
The decision highlights a growing tension between two fundamental principles of bankruptcy law: (1) an entity must have proper corporate authority under its organizational documents and applicable state law to seek bankruptcy relief; and (2) prepetition agreements that prospectively prohibit bankruptcy filings or waive the debtor’s rights under the Bankruptcy Code are void as against federal public policy. The Delaware bankruptcy court held that, under the specific facts of the case before it, federal public policy prevailed.
While the specific circumstances in the Delaware case may have been sui generis, the decision signals an increasing willingness on the part of bankruptcy courts to scrutinize bankruptcy-remote structures and, if necessary, challenge lenders’ efforts to control their borrower’s access to bankruptcy relief, especially where fiduciary duties of the person making the decision to seek bankruptcy relief are abrogated. The decision also serves as an important reminder to lenders: bankruptcy-remote does not necessarily mean bankruptcy-proof.
Intervention Energy Holding, LLC (“IE Holdings”) and its wholly-owned subsidiary Intervention Energy, LLC (“IE”, and, together with IE Holdings, the “Intervention Energy”) are private oil and natural gas exploration and production companies with operations almost entirely located in North Dakota. Both IE Holdings and IE are limited liability companies organized under the laws of the State of Delaware.
On January 6, 2012, Intervention Energy and an energy fund ( “Lender”) entered into a note purchase agreement pursuant to which Lender provided up to $200 million in senior secured notes (of which approximately $140 million in principal amount were outstanding on the petition date). After a covenant default under the senior secured notes in October 2015, Intervention Energy entered into a forbearance agreement with Lender on December 28, 2015. The forbearance agreement provided, among other things, that Lender would waive all defaults under the secured notes if Intervention Energy raised $30 million of equity capital to pay down a portion of the secured notes by June 1, 2016. As a condition to effectiveness, IE Holdings agreed to amend its LLC operating agreement to (a) admit Lender or its affiliate as a member of IE Holdings with one common unit and (b) require approval of each holder of common units of IE Holdings prior to any voluntary bankruptcy filing for IE Holding or IE. IE Holdings so amended its operating agreement and delivered a single common unit to Lender for a capital contribution of $1.00. All of IE Holdings’ other 22,000,000 common units are held by Intervention Energy Investment Holdings, LLC.
On May 20, 2016, IE Holdings and IE commenced chapter 11 cases in the Delaware bankruptcy court. Shortly after the filing, Lender moved to dismiss the chapter 11 cases on the ground that the filings were not properly authorized because Lender did not consent to the filing, as required under IE Holdings’ operating agreement.
In its motion to dismiss, Lender argued that (a) an entity may only commence a bankruptcy case if it properly authorized to do so under applicable state law, (b) under IE Holdings’ operating agreement, its board of managers was only authorized to file a bankruptcy petition if all unitholders approved such a decision, and (c) because Lender, as a unitholder, did not approve the filing, IE Holdings lacked the requisite corporate authority to file the petition. Lender further noted that, under the Delaware LLC Act, a Delaware LLC may agree to eliminate its member’s fiduciary duties (save for the implied contractual covenant of good faith and fair dealing), which is just what IE Holdings did in its operating agreement.
Intervention Energy responded that the provision in IE Holdings’ LLC operating agreement requiring Lender’s consent to file for bankruptcy was void as a matter of federal public policy, which uniformly disfavors contractual provisions precluding business entities from availing themselves of the rights afforded under the Bankruptcy Code. In this regard, Intervention Energy also argued that by abrogating the fiduciary duties of the unitholders, including Lender as holder of the “golden share,” the LLC amendment eliminated what could have otherwise been the redeeming factor of the arrangement with Lender.
III. Bankruptcy Court’s Ruling
The bankruptcy court held that the provision requiring Lender’s consent, as a unitholder, in order for IE Holdings to file for bankruptcy was void as a matter of federal public policy.
Here, the bankruptcy court found that the consent provision added to IE Holdings’ LLC operating agreement was “tantamount to an absolute waiver” because:
the provision at issue “place[d] into the hands of a single, minority equity holder the ultimate right to eviscerate the right of” IE Holdings to seek federal bankruptcy;
the nature and substance of the minority equity holder’s “primary relationship with the debtor is that of creditor—not equity holder;”
the minority equity holder “owes no duty to anyone but itself in connection with [the] LLC’s decision to seek federal bankruptcy relief;” and
Lender “unequivocally intend[ed] . . . to reserve for itself the decision whether the LLC should seek federal bankruptcy relief.”[ix]
Notably, the bankruptcy court did not single out any particular factor as decisive. Rather, it appears that it was the combination of the foregoing factors that ultimately swayed the court to invalidate the consent provision as against federal public policy.
It is well-settled that an entity must have proper corporate authority under the entity’s organizational documents and applicable state law to file for bankruptcy.
These two fundamental propositions have come into conflict in connection with lenders’ efforts to require borrowers, as part of providing secured financing, to form special purpose entities (“SPE”) or establish other corporate limitations that are designed to insulate the borrowing entity (or structure) from a bankruptcy filing.
Typically, the SPE’s organizational documents will contain a number of restrictions intended to make it unlikely that the SPE becomes insolvent as a result of its own activities and/or to ensure that the SPE is insulated from the consequences of any related party’s insolvency. These restrictions include:
a. limiting the SPE’s ability to incur indebtedness (other than its principal secured debt);
b. limiting the SPE’s activities to owning and operating the collateral securing the subject debt;
c. prohibiting the SPE from consolidating or combining with another entity, liquidating or winding up, and merging or selling substantially all of its assets; and
d. requiring the SPE to have an “independent” director (in the case of a corporation) or member (in the case of an LLC) whose vote is required to file a bankruptcy petition.
SPE structures are used in a variety of circumstances, including property-specific loan transactions, transactions involving the pooling of mortgage loans, or credit lease transactions.
However, bankruptcy-remote features are also found outside the context of the typical SPE structure. For example, in connection with forbearance agreements, lenders have in some instances required borrowers to amend their organizational documents to (i) add an “independent” director/member to their boards, (ii) require that such “independent” director/member be selected from an approved list, (iii) require that such director’s/member’s consent is necessary for the borrower to file for bankruptcy, and (iv) disclaim any fiduciary duties of such independent director/member to the borrower’s parent. The ostensible goal of this arrangement is to block (or make extremely unlikely) a voluntary bankruptcy petition—in lieu of having the borrower directly agree not to file for bankruptcy, which would run afoul of the general prohibition against contracting away bankruptcy rights. In addition, structures involving the issuance of a "golden share" to the secured lender (as was the case in Intervention Energy) have been used by secured lenders. Lenders have argued that these bankruptcy-remote structures are critical to limit credit risk, which, in turn, reduces the cost of capital for borrowers, especially those in distressed situations.
Until recently, the few bankruptcy courts that have faced challenges to bankruptcy-remote structures have upheld them and dismissed cases where the requisite consent from the lender or "independent" director/member was lacking. For example, in Global Ship Sys., a Georgia bankruptcy court dismissed a chapter 11 case where the filing had not been authorized by the debtor’s class B shareholder, in contravention of the debtor’s operating agreement.
Moreover, in DB Capital Holdings, the 10th Circuit B.A.P. affirmed, in an unpublished decision, a Colorado bankruptcy court’s dismissal of a chapter 11 case on the ground that the debtor’s manager was not authorized to file the bankruptcy petition.
However, bankruptcy-remote SPE structures are not necessarily bankruptcy-proof. For example, in General Growth Properties, property-level lenders sought to dismiss the chapter 11 cases of several of General Growth’s property-level subsidiaries as bad faith filings, including on the grounds that (i) the filings were engineered by replacing the independent directors on the eve of bankruptcy and (ii) the SPEs were not in financial distress, and hence the filings were premature.
More recently, in In re Lake Michigan Beach Pottawatamie Resort LLC, an Illinois bankruptcy court held that a lender’s consent provision in a borrower’s LLC agreement was unenforceable as a matter of federal public policy and applicable Michigan state law.
As noted above, the bankruptcy court in Intervention Energy similarly took issue with the fact that Lender, as holder of the “golden share,” owed no duty to anyone but itself.
While the specific facts of Intervention Energy were perhaps sui generis—the secured creditor could block a bankruptcy filing through a single “golden share”—the case may open the door for future debtors to challenge bankruptcy-remote structures, especially where the LLC agreement abrogates the fiduciary duties of the “blocking” director/member, as was the case in both Intervention Energy and Lake Michigan Resort.
The bankruptcy court in Intervention Energy also briefly addressed the decisions in Global Ship Sys. and DB Capital Holdings, both of which had been cited by Lender in support of its position that the consent provision in IE Holdings’ LLC operating agreement should be enforced. While the court described the Global Ship Sys. case as “closest on point,” it nevertheless distinguished it on the ground that
the method by which the creditor in Global Ship Sys. received its equity interests was not subject to question or analysis. There is no way to compare that creditor’s interests to [Lender]’s contract for one golden share solely for the purpose to control any potential filing.[xxxiv]
The footnote thus reveals the court’s willingness to carefully scrutinize the circumstances under which a secured lender obtained its consent rights—at the time of the original funding vs. as a condition to forbearance—and to take into account the magnitude of the lender’s equity position—20% in Global Ship Sys. vs. 0.00005% (i.e., 1/2,000,000) in Intervention Energy. While it is not entirely clear, the footnote suggests that the court’s holding is limited to circumstances where the LLC amendment was entered into as a condition to the lender’s agreement to forebear from exercising remedies.
As for the 10th Circuit B.A.P.’s decision in DB Capital Holdings, the court noted, without any discussion, that it disagreed with the holding in that case.
There are two ways of reading the Intervention Energy decision. A narrow reading would suggest that the case, as precedent, is limited to circumstances where the bankruptcy-remote features are added as part of a forbearance or restructuring agreement. If that is the proper interpretation of the decision, financial participants in typical bankruptcy-remote structures have little to fear. However, it could be argued that the decision should be read more broadly, namely as critical of bankruptcy-remote structures where (a) the lender has no (or only an extremely limited) economic stake qua shareholder or unitholder, (b) the bankruptcy-remote provisions were incorporated to block any bankruptcy filing, and (c) the fiduciary duties of the decision-maker appointed pursuant to the bankruptcy-remote provisions are so circumscribed that it is practically impossible for a bankruptcy filing to be authorized. If that is the proper reading of the decision, then certain bankruptcy-remote structures could potentially be at risk. While the Intervention Energy decision is, of course, not binding precedent on any other court, it is noteworthy as it comes from one of the most influential bankruptcy courts in the United States.
In any event, the Intervention Energy decision serves as an important reminder to all lenders contemplating bankruptcy-remote structures: bankruptcy-remote does not necessarily mean bankruptcy-proof. Accordingly, lenders should always consider additional safeguards, including so-called “bad boy” guaranties, i.e., non-recourse guaranties by the borrower’s controlling shareholder(s), which become recourse guaranties upon the occurrence of certain enumerated bad acts of the borrower, including the borrower’s bankruptcy filing.
(B.A.P. 10th Cir. 2010).