Bankruptcy Remoteness Survives
February 21, 2011
This article was published in the National Law Journal.
A bankruptcy appellate panel recently dismissed a Chapter 11 bankruptcy filed by a limited liability company manager-member in violation of the operating agreement. The decision was based on the doctrine of bankruptcy remoteness and was anchored in organizational documents. Bankruptcy remoteness describes a borrower's legal characteristics that make its bankruptcy less likely and that range from selecting a business entity that is ineligible to file bankruptcy to voting, notice and operational restrictions in organizational and loan documents, and to third-party support agreements and guarantees against "bad acts" such as filing bankruptcy without lender consent. The appellate decision sharpens the distinctions among internal corporate authority to file bankruptcy, ineligibility to be a debtor under the Bankruptcy Code and contractual devices imposed by a creditor, and it should restore some confidence to creditors.
The decision of the U.S. Court of Appeals for the 10th Circuit Bankruptcy Appellate Panel in DB Capital Holdings LLC v. Aspen HH Ventures LLC (In re DB Capital Holdings LLC), No. 10-046, 2010 Bankr. Lexis 4176 (B.A.P. 10th Cir., Dec. 6, 2010) is welcome news to creditors after In re General Growth Properties Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009) (holding a popular bankruptcy-remoteness feature, the independent manager, ineffective in this case and questioning the assumption that an independent manager could always veto a bankruptcy). The specifics of these cases and In re RiverAir LLC, No. 04-17546 (SMB) (Bankr. S.D.N.Y. Nov. 29, 2004), reveal some mechanisms for strengthening remoteness.
In General Growth Properties, the debtor parent company owned and operated a centralized cash-management system for its hundreds of project-level, mall-owning subsidiary special-purpose entities. After unsuccessfully seeking to open restructuring negotiations about the not-yet-mature debt of some subsidiaries, the parent company carefully used its equity rights as sole member of the special-purpose entities to replace their independent managers, whom it judged too inexperience or unsympathetic to a jointly administered group bankruptcy, on the eve of the bankruptcy filing.
The General Growth secured creditors were highly disappointed to see that the special-purpose entities were not as bankruptcy-remote as rated and were threatened with losing the substantial contractual right to sweep cash flow from the project level to debt at the same project. The specter of substantive consolidation loomed after court approval of the continued use of the central cash-management system to sweep mall-level excess cash to support parent operations.
The secured creditors requested dismissal because of the debtors' objective and subjective bad faith. In the objective prong of its analysis, among several issues, the court reviewed the complexity of the business judgments and the fiduciary duties of managers. It concluded, "[I]f the [secured-creditor] Movants believed that an 'independent' manager can serve on a board solely for the purpose of voting 'no' 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." 403 B.R. at 64. The independence of the creditor-friendly manager or director is inherently limited by his fiduciary duties to the entity and its equityholders.
In the subjective prong of the bad-faith analysis, the secured creditors relied on the lack of notice to the replaced independent managers and the secured creditors. Compliance with the terms of the operating agreements and the absence of any contractual notice provision left the court unwilling to find that the "surreptitious firing" was sufficient to require dismissal. Id. at 68. The evasion of the intent of the common special-purpose-entity independent-manager provisions thus proved successful.
Some enhancements to independence have been identified — for example, terms for the independent managers, supermajority requirements for votes for bankruptcy filings, prior notice of board membership changes, board observer rights and equity observer rights. More enhancements will be sought, but the manager or director level may always have the corporate law fiduciary spell out provisions that the secured-loan documentation requirements are powerless to alter. The General Growth court explained that " '[w]hen a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.' " Id. at 64, quoting North Am. Catholic Educ. Programming Found. Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007).
For one General Growth special-purpose entity, dismissal was sought because the entity was an Illinois trust, and thus an entity not eligible to file a bankruptcy petition rather than a business trust eligible for such relief. See 11 U.S.C. 101(9)(A)(v), (41). The financial strength of the borrower and the extra administrative burdens persuaded the lender to leave the mall ownership and the mall business operations in the same entity. In the end, there was little dispute that the debtor actively engaged in business and qualified for relief as a business trust. 403 B.R. at 71-72. Whether a particular business and asset ownership arrangement can separate the collateral from the business enough to remain a passive trust and ineligible for bankruptcy relief will be one challenge in the further development of statutory trusts as special-purpose entities ineligible for relief.
In DB Capital, three operating-agreement provisions supported dismissal. First, the agreement imposed an express limitation on filing bankruptcy: "The Company…to the extent permitted by applicable law, will not institute proceedings to be adjudicated bankrupt or insolvent; or consent to the institution of bankruptcy or insolvency proceedings against it; or file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy." 2010 Bankr. Lexis, at *6. The court upheld this limitation among equityholders, notwithstanding the public policy against prospectively prohibiting bankruptcy filings. See id., citing In re Cole, 226 B.R. 647, 651-52 (B.A.P. 9th Cir. 1998). The court distinguished the cases invalidating prospective prohibitions on bankruptcy filings as against public policy because they involved agreements between debtors and third-party creditors, and because no such lender coercion led to the adoption of the provision at issue. Id. at *10. DB Capital builds confidence at the appellate level that, in proper circumstances, bankruptcy remoteness will be enforced with the ultimate creditor wish of dismissal.
Second, the operating agreement required the manager to "conduct and operate its business as presently conducted." Third, it prohibited the manager from "do[ing] any act that would make it impossible to carry on the ordinary business of the Company" without prior written consent of all members. Id. at *10, 17. These limitations were supported by an uncommon provision in the Colorado Limited Liability Company Act that requires the consent of each member to authorize an act that is not in the ordinary course of business of the company. Id. at *8, citing Colo. Rev. Stat. § 7-80-401 (West 2010). There are no such corresponding statutory limitations in the Delaware or New York LLC acts, which emphasize management business judgment and freedom of contract. The court accepted that "filing a bankruptcy petition is an act that makes it impossible to carry on a company's ordinary business, even though the company's ability to continue to 'do business' is not completely eliminated." Id. at *18.
As interpreted, the operating agreement withheld corporate authority to file a bankruptcy petition without the consent of all members. In DB Capital, the moneyed investor member of the LLC apparently initiated the limitation. The requirement that debtors comply with state corporate law to obtain internal authority to file a bankruptcy is a long-established limitation. Price v. Gurney, 324 U.S. 100 (1945).
Bankruptcy remoteness would be enhanced by requiring LLC member or stockholder approval, perhaps even unanimous approval, for a bankruptcy filing. Adding an independent member or independent stockholder to the prospective debtor could add a new procedural protection and new business judgment to the consideration of a bankruptcy. Reinforcing the independent equityholder's incentives with a guaranty limited to "bad acts" including commencing a bankruptcy could be effective. Extension of controlling shareholder fiduciary duty by analogy to an independent director or manager would need study beyond the scope here. Such "bad acts" or nonrecourse carve-out guaranties have been effective in protecting some lenders from bankruptcies whose projects seemed adequately capitalized initially.
In RiverAir LLC, then-Chief Judge Stuart Bernstein delivered an oral opinion dismissing a Chapter 11 of a New York LLC early. The dismissal relied on combining the requirement for member approval with a pledge agreement that transferred all membership interests and all voting rights to the secured lender effective immediately upon the lender's notice of default. See Paul Rubin, "Strategic Thinking For the Mezzanine Lender," 28 Am. Bankr. Inst. J. 42 (2009).
From the perspective of creditors, Bankruptcy remoteness can be improved, increasing protection of collateral, limiting perceived bankruptcy credit risks and ultimately reducing borrower expense.