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By Gardner F. Davis and John J. Wolfel Jr.
Gardner F. Davis is a partner and corporate lawyer with Foley & Lardner LLP. He advises boards of directors and special committees in regard to fiduciary duty issues in various contexts, and he has extensive experience restructuring financially distressed enterprises, both inside and outside of bankruptcy.
John J. Wolfel, Jr. is a partner and corporate lawyer with Foley & Lardner LLP. His practice is focused on corporate and securities laws matters, including mergers and acquisitions and securities law compliance counseling.
Bankruptcy remote special purpose entities – commonly known as BREs – are routine in financing transactions. They protect secured lenders by segregating borrowers' assets and business operations from those of parent and affiliates. Most BREs are formed simultaneously with the closing of loans to isolate lenders' collateral from potential claims by creditors of the parent and affiliates.
Another goal – reducing the chance that borrowers voluntarily file for bankruptcy – is aided by BRE governing documents that require approval of an independent director or member (chosen by the lender) to authorize a voluntary filing. This “blocking director” is intended to create a hurdle that bankruptcy courts will respect. Lenders and borrowers frequently assume the blocking director is not really independent, but will act in the lender's best interest and likely won't approve the bankruptcy filing.
BREs are usually organized in Delaware and the state's LLC Act provides great flexibility in organizing an LLC, permitting the elimination or modification of the traditional fiduciary duties applicable to managers and members. Lenders usually require the blocking director to consider interests of creditors and frequently eliminate the blocking director's fiduciary duty to the parent and affiliates. Sometimes, the lender eliminates all of the blocking director's fiduciary duties.
This structure substantially reduces the likelihood that the borrower will be dragged into bankruptcy because of financial problems of its parent or affiliates. But there is uncertainty regarding the BRE's ability to file bankruptcy when the BRE itself suffers financial distress and cannot repay the lender according to the loan terms. Then, the question becomes, under what circumstances can the BRE file bankruptcy without the blocking director's consent?
The answer requires examination of the tension created by the federal Bankruptcy Code and supporting public policy, the Delaware statute creating LLCs and the common law fiduciary duty applicable to trustees, corporate directors and similar decision makers.
The matter remains in the early stages of development, without a definitive answer in existing case law. A bankruptcy court would probably focus on whether a reasonable business person would conclude that the BRE has a reasonable prospect for successfully reorganizing under Chapter 11. The court would likely permit a bankruptcy to proceed where the debtor can repay the secured lender in full with interest and salvage meaningful additional value for the BRE.
The standard of judicial review often determines the outcome of litigation challenging a director's decisions. Courts usually review actions by directors under the deferential “business judgment” rule, which creates a presumption that in making a business decision, directors acted on an informed basis, in good faith and in an honest belief that the action taken was in the best interests of the company.
However, there is a strong argument that the bankruptcy court should review the blocking director's refusal to authorize a bankruptcy under either the enhanced scrutiny or entire fairness standards, both of which substantially increase the likelihood that the bankruptcy judge will ultimately permit the BRE to pursue reorganization in bankruptcy.
The bankruptcy court's analysis for purposes of determining whether to ignore the blocking director approval requirement would likely mirror the court's consideration of the issues presented by the motion to dismiss for bad faith (often filed by secured creditors at the beginning of single asset bankruptcies involving non-BRE debtors). Therefore the blocking director's refusal to consent makes little practical difference with respect to whether a bankruptcy court ultimately would permit a financially distressed BRE to pursue bankruptcy.
It is against public policy for a debtor to waive the prepetition protection of the Bankruptcy Code. This prohibition of prepetition waiver has to be the law; otherwise, astute creditors would require their debtors to waive. Business entities have been held to have, in certain instances, rights akin to that of natural persons. The federal public policy to be guarded here is to assure access to the right of a person, including a business entity, to seek federal bankruptcy relief as authorized by the Constitution and enacted by Congress.
Most courts have held that an absolute prohibition against filing bankruptcy in an entity's organization documents, when included at the request of a lender, is unenforceable as a matter of public policy.
But bankruptcy law is equally clear that corporate formalities and state law must be satisfied in commencing a bankruptcy case. A bankruptcy case filed on behalf of an entity without authority under state law and the governing documents is improper and must be dismissed. Bankruptcy courts must look to state law to determine who has authority to commence a bankruptcy case on behalf of a limited liability company organized pursuant to state law.
Several bankruptcy courts have addressed BRE bankruptcy filings and determined, based on various alternative reasoning, that the blocking director provision does not prevent a voluntary bankruptcy. None of these cases requires a court to rule that the traditional BRE structure is invalid on its face. However, they indicate the Bankruptcy Court will be sympathetic with the BRE's desire to file bankruptcy and will not tolerate a blocking director structure, which in operation is tantamount to an absolute bar to bankruptcy.
General Growth Properties, Inc.
In re General Growth Properties, Inc. , 409 B.R. 43 (Bankr. S.D.N.Y. 2009), involved the bankruptcy of a large real estate investment trust, in which numerous shopping centers were owned by separate BREs. The lenders believed that the General Growth BREs were bankruptcy-proof because the blocking directors would not authorize a bankruptcy filing.
Prior to filing bankruptcy, General Growth secretly replaced the blocking directors selected by the lenders. The new, pro-borrower blocking directors authorized the bankruptcy filing. Therefore the bankruptcy court in General Growth never directly addressed the issue of whether the blocking director's consent was required.
The General Growth court addressed the BRE arrangement within the context of the lenders' motion to dismiss the case, based in part on the theory that the replacement of the blocking directors constituted bad faith. The court noted that “some of the lenders thought the independent directors were obligated to protect their interests alone. As articulated by debtor's counsel, ‘the assumption by the lenders was that the independent director was not really independent.’”
The court also stated “if [the lenders] believed that an ‘independent’ manager can serve on a board solely for the purpose of voting [against] a bankruptcy filing because of the desires of a secured creditor, they were mistaken. As the Delaware cases stress, directors and managers owe their duties to the corporation and, ordinarily, to the shareholders.”
The General Growth court expressly found that “Independent Managers did not have a duty to keep any of the Debtors from filing a bankruptcy case.”
Lake Michigan Beach Pottawattamie Resort LLC
In In re Lake Michigan Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016), the lender required the borrower's operating agreement designate the lender as a “special member,” with the right to approve or disapprove any bankruptcy filing. The operating agreement provided that the lender was not obligated to consider any interests or desires other than its own, and had “no duty or obligation to give any consideration to any interest of or factors affecting the Company or the Members.” The BRE nevertheless filed bankruptcy without the consent of the special member.
The court recognized that the “blocking director is the lynchpin that holds together a bankruptcy remote special purpose entity, formed to ring fence assets from creditors other than the secured creditor who is unwilling to lend otherwise and for whom the structure is made.” The court explained that lenders use this structure because “a simpler, absolute prohibition against filing for bankruptcy will likely be deemed void as against public policy.” The court recognized that “corporate formalities and state corporate law must also be satisfied in commencing a bankruptcy case.” “Put another way, the long-standing policy against contracting away bankruptcy benefits is not necessarily controlling when what defeats the rights in question is a corporate control document instead of a contract.”
“Common wisdom dictates that corporate control documents should not include an absolute prohibition against filing bankruptcy. Even though the blocking director structure… impairs or in operation denies a bankruptcy right, it adheres to that wisdom. It has built into it a saving grace: the blocking director must always adhere to his or her general fiduciary duties to the debtor in fulfilling the role. That means at least theoretically, there will be a situation where the blocking director will vote in favor of a bankruptcy filing, even if in so doing he or she acts contrary to purposes of the secured creditor for whom he or she serves.”
The Pottawattamie court found that “considerations of fiduciary duties and public policy concerns further extends to a situation where the blocking director position is a member of a limited liability company.” “The essential playbook for a successful blocking director structure is this: the director must be subject to normal director fiduciary duties and therefore in some circumstances vote in favor of a bankruptcy filing, even if it is not in the best interests of the creditor that they were chosen by.”
The Pottawattamie court also found that under Michigan law, members of a limited liability company have a duty to consider the interests of the company, not only their own interests. By excluding the debtor's interest from consideration by the lender when acting as a special member, thereby allowing the lender to consider only its own best interests, the provision “expressly eliminates the only redeeming factor that permits the blocking director/member construct. The. . . provision that [the lender's] consent was required in order for the Debtor to petition for relief is, therefore , unenforceable, both as a matter of Michigan corporate governance and bankruptcy law. What the court is left with is this – the blocking member provision . . . is void.”
In re Intervention Energy Holdings, LLC , 553 B.R. 258 (Bankr. D. Del. 2016), involved a Delaware limited liability company that issued one equity unit to its lender for the price of one dollar under a so-called “golden share” arrangement. The borrower's operating agreement required unanimous approval of all members to file bankruptcy and the lender naturally refused to consent.
The Intervention Energy court recognized that “any attempt by a creditor in a private pre-bankruptcy agreement to opt out of the collective consequences of a debtor's future bankruptcy filing is generally unenforceable. The Bankruptcy Code pre-empts the private right to contract around its essential provisions.” “Yet to contract away the right to seek bankruptcy relief is precisely what both parties here have attempted to accomplish.”
“The federal public policy to be guarded here is to assure access to the right of a person, including a business entity, to seek federal bankruptcy relief as authorized by the Constitution and enacted by Congress. It is beyond cavil that a state cannot deny to an individual such a right. I agree with those courts that hold the same applies to a “corporate” or business entity, in this case an LLC.
A provision in a limited liability company governance document obtained by contract, the sole purpose of which is to place into the hands of a single minority equity holder 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 himself in connection with an LLC's decision to seek bankruptcy relief, is tantamount to an absolute waiver of a right, and, even if arguably permitted by state law, is void as contrary to federal public policy.”
In re Kingston Square Associates , 214 B.R. 713 (Bankr. S.D.N.Y. 1997), involved the lender's motion to dismiss a bankruptcy for bad faith because the borrower circumvented the bankruptcy proof provisions by causing friendly creditors to institute an involuntary bankruptcy. The independent director appointed by the lender refused to approve the bankruptcy filing.
The Kingston Square court emphasized the relatively significant amount of compensation paid to the independent director by the lender and its affiliates for its services as a blocking director in connection with various financing transactions. The bankruptcy judge found that the blocking director's conduct was a mitigating factor in favor of the borrower on the issue of bad faith:
“But [blocking director's] claim of ignorance as to the limited partners, who are plainly analogous to stockholders, proves too much to credit. [The blocking director] is an attorney who worked on sophisticated financings. It is inconceivable that he would not understand that the corporate general partners of which he was a director bore fiduciary obligations to the limited partners. (That is the stuff of a basic corporate law course in law school.) Yet he completely ignored the limited partners' plight in the face of foreclosure actions instituted by the group that placed him on the boards of directors of these and other companies and saw to it that he was paid fees, even though the consequence of foreclosure would be to not simply injure but to eliminate the limited partners' interests. [Blocking director's] failure to carry out his fiduciary role to creditors and the limited partners was exemplified by his failure to ratify the involuntary filings during the December 1996 board meeting. If he was an “independent” director, it is in name only.”
The court ruled in favor of the borrower on the issue of good faith and therefore permitted the bankruptcy to proceed and did not need to reach the question of whether the bankruptcy proof provision was void against public policy. However, Kingston Square clearly shows hostility toward the blocking director's refusal to act in the best interest of the borrower in order to please the lender who appointed him.
The Delaware Limited Liability Company Act, 8 Del. Code Ann. § 18-1104, states that “in any case not provided for in this chapter, the rules of law and equity including … fiduciary duties shall govern.” This means that a manager of a Delaware LLC owes equitable fiduciary duties unless modified or eliminated by the express language of the operating agreement.
Like the Delaware General Corporation Act, the LLC Act does not explicitly provide for fiduciary duties of loyalty and care; consequently the traditional rules of law and equity govern. A fiduciary relationship is a situation in which one person reposes special trust in and reliance on the judgement of another or where a special duty exists on the part of one person to protect the interests of another. The manager or managing member of an LLC is vested with discretionary power to manage the business and easily fits the definition of fiduciary.
Both LLC members and managers active in a business and corporate directors have the fiduciary duties of loyalty and care, which impose an affirmative obligation on members or managers to protect the interests of the business and act in good faith.
However, the limited liability company agreement can expand, restrict or eliminate fiduciary duties. The Delaware LLC Act, 6 Del. Code § 18-1101(e), gives members broad discretion in structuring the LLC and organizing the relationships between members and managers. Members and managers of an LLC will owe fiduciary duties unless the operating agreement unambiguously states otherwise.
Lenders frequently require that the BRE operating agreement restrict, and sometimes eliminate, the blocking director's fiduciary duty. However, the case law discussed above, particularly Pottawattamie and Intervention Energy, make it clear that elimination of the blocking director's fiduciary duty to act in the best interest of the BRE violates federal public policy supporting access to bankruptcy, and will excuse the need for blocking director's consent.
Having established that the blocking director must owe a fiduciary duty to the BRE, the bankruptcy court presumably should review the blocking director's refusal to authorize a bankruptcy filing to determine whether the duty has been breached.
The corporate director's fiduciary duty to the company is generally expressed in terms of “duty of care,” “duty of loyalty” and “good faith.” The Delaware LLC Act draws on both limited partnership and corporate law. Both the general partners of a Delaware limited partnership and the directors of a Delaware corporation have duties of care, loyalty and good faith.
The fiduciary duty of care requires that the blocking director, like a corporate director, exercise the care of ordinarily prudent and diligent persons under similar circumstances. Gross negligence is usually the standard by which a court evaluates a potential breach of the duty of care. The duty of loyalty mandates that the best interest of the company take precedence over any interest possessed by a director, officer or controlling shareholder. The blocking director must promote the interests of the BRE without regard for personal gain.
The requirement to act in good faith is a subsidiary element, i.e., a condition, of the fundamental duty of loyalty. “Bad faith,” sometimes referred to as the lack of good faith, has been defined as a conscious and intentional disregard of responsibilities, adopting a “we don't care about the risk” attitude. Bad faith may be shown where a director intentionally acts with a purpose other than advancing the best interests of the corporation or with the intent to violate applicable positive law or where a director intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for the duties. The reason why the director intentionally fails to pursue the best interests of the corporation makes no difference. Bad faith can be the result of any motivation that may cause a director to place her own interests, preferences or appetites before the welfare of the company, including greed or fear.
The Delaware LLC Act prohibits elimination of the implied contractual covenant of good faith and fair dealing. 8 Del. Code Title 6 § 1101(c). This contract law concept is distinct from the fiduciary duty of good faith and serves primarily to restrain a contract party's abusive use of discretion. The Delaware court in Gerber v. Enterprise Products Holdings, LLC, 67 A.3d 400, 418-419 (Del. 2013) explained:
“Fair dealing” is not akin to the fair process component of entire fairness, i.e., whether the fiduciary acted fairly when engaging in the challenged transaction as measured by duties of loyalty and care … . It is rather a commitment to deal “fairly” in the sense of consistently with the terms of the parties' agreement and purpose . Likewise “good faith” does not envision loyalty to the contractual counterparty, but rather faithfulness to the scope, purpose and terms of the parties' contract. Both necessarily turn on the contract itself and what the parties would have agreed upon had the issue arisen when they were bargaining originally. (Emphasis added).
This implied contractual duty of good faith and fair dealing owed by a blocking director to the parent of the BRE probably requires that the blocking director consider the possibility of a voluntary bankruptcy. However, the “abuse of discretion” standard of review for the implied contractual covenant of good faith is much less favorable to the parent than the traditional breach of fiduciary duty standard of review discussed below.
In Allen v. El Paso Pipeline GP Co. LLC, 113 A.3d 167 (Del. Ch. 2014), the court addressed a limited partnership agreement that disclaimed all fiduciary duty and determined that the sole test was a contractual duty of good faith to the company, not the limited partner. The court held that the contractual test for good faith is subjective rather than objective. The definition of “good faith” in the LP Agreement is satisfied “if the actor subjectively believes that it is in the best interest of [the Partnership].” When applying the test, “the ultimate inquiry must focus on the subjective belief of specific directors accused of wrongful conduct.” “Objective facts remain logically and legally relevant to the extent they permit an inference that the defendant lacked the necessary subjective belief.” The El Paso court explained it may be reasonable to infer subjective bad faith in less egregious transactions when a plaintiff alleges objective facts indicating that a transaction was not in the best interests of the partnership and the directors knew those facts.
LLC managers, like corporate directors, are protected against lawsuits asserting deficient conduct by the “business judgment rule” — which is a standard of judicial review for fiduciary conduct, not a description of a duty or a standard for determining whether a breach has occurred. The rule is applied to determine whether the fiduciary's decision can be subject to challenge in court.
The rule is a judicially created presumption that decisions are made by informed and disinterested directors in the good faith belief that the decision will serve the best interests of the company. If the plaintiff cannot overcome the presumption, usually by specific proof of conflict of interest, illegality, fraud or bad faith, the rule prohibits the court from going further and examining the underlying business decision's merits. If the presumption of the rule is rebutted, then the burden of proving entire fairness shifts to the director defendants. A plaintiff can overcome the presumption by pleading specific facts from which a reasonable inference can be drawn that a majority of the board was interested or lacked independence with respect to the relevant decision. In the context of a blocking director's refusal to authorize a bankruptcy, debtor's counsel would need to show the bankruptcy court specific facts that gave the lender influence over the blocking director.
The concept of director “interestedness” comes into play regarding potential conflicts of interest. A director is considered interested when he or she will receive a personal financial benefit from the transaction that is not equally shared by the stockholders, or will suffer a detrimental impact from the proposed transaction.
The facts will likely vary case to case, but debtor's counsel presumably can make a persuasive argument that the blocking director earns substantial income from providing this service for lenders, and that this income constitutes a personal interest for the blocking director that calls into question her interestedness.
Independence exists if a director's decision is based on the corporate merits of the subject before the board rather than on extraneous considerations or influence. The Delaware Supreme Court in Cede & Co. v. Technicolor, Inc. , 634 A.2d 345, 362 (Del. 1992), has “defined a director as being independent only when the director's decision is based entirely on the corporate merits of the transaction and is not influenced by personal or extraneous considerations. By contrast, a director who receives a substantial benefit from supporting a transaction cannot be objectively viewed as disinterested or independent.”
A director is beholden to the lender if the director receives a benefit upon which the director is so dependent or is of such subjective material importance that its threatened loss might create a reason to question whether the director is able to objectively consider the corporate merits of a challenged transaction. The bankruptcy court must determine, based on a totality of the circumstances, whether the blocking director is, for any substantial reason, incapable of making a decision based only on the BRE's best interests.
The issue is not the integrity of the directors, but their objectivity and impartiality, both in fact and perception, and whether their decision was anything but the exercise of considered and unbiased judgement.
The blocking director's business of providing services for lenders and the potential adverse impact on that business from authorizing a bankruptcy presumably will support an argument that the blocking director is not actually independent.
Delaware Courts have decided a series of high-profile cases in connection with the sale of a company that requires the application of “enhanced judicial scrutiny” to probe the deliberative process as well as the reasonableness of the directors' decisions.
The Delaware Chancery Court in Blackmore Partners, L.P. v. Link Energy LLC, 864 A.2d 80, 84 (Del. Ch. 2004), relying on corporate case law, held that “the allegation that the Defendant Directors [of a Delaware LLC] approved a sale of substantially all of [the LLC's] assets and a resultant distribution of proceeds that went exclusively to the company's creditors raises a reasonable inference of disloyalty or intentional misconduct.”
The independent manager's decision whether to authorize a bankruptcy filing or merely permit the secured creditor to foreclose on all the BRE's assets and retain all proceeds arguably would be analogous to a sale of the company and therefore justifies application of enhanced judicial scrutiny.
In Delaware, when the controlling stockholder acquires a company in a conflict of interest transaction, the operative standard of judicial review ordinarily is the even more stringent entire fairness test, with the defendant having the burden of persuasion. Not even an honest belief that the transaction was entirely fair will be sufficient to establish entire fairness. The transaction itself must be objectively fair, independent of the board's belief.
The lender's relationship with the blocking director arguably is similar to the role of a controlling shareholder who appoints the corporate board that approves the controlling shareholder's acquisition of the company in a freeze-out merger. The decision whether to file bankruptcy clearly involves a conflict of interest for the lender. The bankruptcy court's potential evaluation of the blocking director's decision not to approve a bankruptcy filing under the entire fairness standard could substantially undercut the tactical advantage the lender hoped to obtain through the blocking director approval process. The bankruptcy court essentially would second guess the blocking director and place the burden of persuasion on the lender to establish that bankruptcy was not in the BRE's best interest. In other words, the lender would need to prove the BRE's bankruptcy reorganization would probably be unsuccessful and unlikely to provide for the full repayment of the secured creditors with interest and a meaningful residual value for the BRE.
The issue before the bankruptcy court when reviewing the blocking director's decision not to file bankruptcy under the strict “entire fairness” standard of review is very similar to the question the bankruptcy court would have faced if the special purpose borrower's operating agreement did not contain a blocking director but was merely a single asset debtor bankruptcy. Absent the blocking director consent requirement, in the event of a bankruptcy, the secured lender probably would ask the bankruptcy court to dismiss the bankruptcy under Bankruptcy Code Section 1112(b) for “cause” on the grounds the case was filed in “bad faith.”
A line of bankruptcy cases involving single asset real estate project bankruptcies show that factors indicating bad faith include situations where the debtor only has one major asset, the debtor's financial condition is, in essence, a two-party dispute between the debtor and the secured creditor, and the bankruptcy is filed to frustrate the lender's right to foreclose on the collateral. As part of the “bad faith” analysis, bankruptcy courts usually consider the borrower's equity (or lack thereof) in the property and the ability to reorganize. This test for bad faith under Bankruptcy Code Section 1112(b) is very similar to the test of whether the blocking director breached her fiduciary duty under the entire fairness standard of review. The outcome probably will hinge on whether the BRE can establish that it intends to reorganize and that it has a reasonable probability that it will eventually emerge from bankruptcy.
Broadly, whether a reasonable business person's conclusion – after reviewing the facts and circumstances – that the BRE's bankruptcy reorganization would likely succeed and provide for the full repayment of the secured creditors with interest and a meaningful residual value for the BRE is an important consideration. It would likely mean that the BRE has a reasonable prospect of convincing the bankruptcy court that the independent manager's refusal to approve the bankruptcy filing constituted a breach of her fiduciary duty that should not prevent the bankruptcy from going forward.
Although the blocking director consent requirement may initially appear to borrowers and lenders as a major impediment to the BRE filing bankruptcy, the practical impact of failure to obtain blocking director consent probably will not make a significant difference in the ultimate outcome in which the BRE has good prospects for a successful reorganization.
Copyright © 2017 The Bureau of National Affairs, Inc. All Rights Reserved.
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