Probably for as long as there has been a bankruptcy law, lenders have attempted to make their loans "bankruptcy proof." The means by which lenders have tried to do so have become more sophisticated in response to the hostility of bankruptcy courts to contractual waivers of bankruptcy law protections. In more recent years, and particularly in the context of loans secured by real property, lenders have fostered the creation of a "bankruptcy remote," special purpose entity (SPE) as the borrower, whose internal governing documents effectively give the lender veto power over the entity's authority to file a bankruptcy petition.
The SPE is a recent variation on the theme of protecting lenders against debtor bankruptcy. The relative dearth of case law addressing the effectiveness of this permutation of bankruptcy proofing may indicate that it is having its desired effect of inhibiting debtors from filing for bankruptcy protection. If history is a guide, however, lenders should not be overconfident of the ability of any mechanism, no matter how clever, to keep them out of bankruptcy court. When subjected to enough pressure, efforts to make loans bankruptcy proof have generally tended to fail.
The availability of bankruptcy protection affects the balance of power in debtor-creditor relations, since bankruptcy law offers numerous protections to the defaulting borrower. Perhaps apart from the ability in certain types of bankruptcy cases to obtain a discharge of prepetition (i.e., prebankruptcy) debts, paramount among these protections is the automatic stay under Bankruptcy Code Section 362. Generally speaking, while a bankruptcy case is pending, an automatic stay prohibits any action to enforce the debtor's prepetition debt, including the commencement or continuation of litigation, as well as nonjudicial enforcement mechanisms such as foreclosure. If a debtor has significant debt secured by collateral (whether real or personal property), the bankruptcy filing is commonly prompted by the secured creditor's efforts to foreclose upon its security interest. Although the same principles apply when the debt is secured, cases in which the debt is secured by real property often bring the power of the automatic stay into sharp relief. In those cases, borrowers routinely file a bankruptcy petition the day before a trustee's sale is set to proceed, thereby stopping the foreclosure process.
While lenders are often successful in obtaining relief from the automatic stay, thereby enabling them to resume foreclosure or other enforcement efforts, the outcome of the relief from stay process is never certain, and the process itself will generally require contested motion practice before the bankruptcy court. Thus, even when relief from stay is granted--a "good" result for the lender under the circumstances--the borrower's bankruptcy filing will delay loan enforcement.
No to Contractual Waivers
Given the added risk, delay, and expense that a bankruptcy filing creates for creditors, it is not surprising that lenders have long engaged in efforts to make their loans bankruptcy proof. These efforts have taken many forms. One common device has been to insert an ipso facto clause into the loan documents. The clause provides that a borrower's bankruptcy filing, or even a borrower's insolvent financial condition, constitutes a breach. Another common device has been to require, as a condition of the loan, that the borrower agree in advance to waive one or more of the benefits of bankruptcy law, such as the right to oppose relief from the automatic stay or the ability to obtain the discharge of a particular debt or of debts in general. Unfortunately for lenders, courts have generally rejected these sorts of provisions as being against public policy.1
At least as far back as 80 years ago, interpreting the Bankruptcy Act (a predecessor to the current Bankruptcy Code), the Southern District of New York held, in In re Weitzen, that an "agreement to waive the benefit of bankruptcy is unenforceable," because "[t]o sustain a contractual obligation of this character would frustrate the object of the Bankruptcy Act."2 Citing to an even earlier case, from the Supreme Judicial Court of Massachusetts,3 the Weitzen court further stated that "[i]t would be repugnant to the purpose of the Bankruptcy Act to permit the circumvention of its object by the simple device of a clause in the agreement, out of which the provable debt springs," since the "Bankruptcy Act would in the natural course of business be nullified in the vast majority of debts arising out of contracts, if this were permissible."4 Over the ensuing decades, numerous courts have reached much the same conclusion and invalidated all sorts of provisions inserted into loan documents that would operate to waive one or another of the benefits of bankruptcy law.5
While courts have generally rejected advance contractual waivers of the benefits of bankruptcy, lenders have had somewhat more success in bankruptcy proofing loans through the creation of bankruptcy remote, SPE borrowers. An SPE "is an independent legal entity that can be used to mitigate the disruption caused by a bankruptcy filing by all or some of the members of a corporate group."6 "Essentially, a lender may be more inclined to provide a secured loan to an independent entity rather than to a complex corporate group with several creditors."7 "Ideally, the SPE will be a newly created corporation, limited liability company, partnership, nonprofit, business trust, or limited liability partnership," although, "most commonly, SPEs are either limited partnerships or limited liability companies."8
SPEs are generally designed to be "bankruptcy remote," in that restrictions on the SPE's activities make it less likely to become insolvent, and in that if the SPE does become insolvent, it is difficult for a majority of board members or managers to put the business into bankruptcy.9 "The SPE's corporate documents will generally contain restrictive provisions requiring that the SPE be limited to its stated purpose of holding the collateral assets, therefore restricting it from engaging in outside activities," and thereby "reducing the risk of the SPE becoming insolvent."10 In addition, an SPE's antibankruptcy provisions will generally require that in order to file for voluntary bankruptcy, the SPE's directors or partners must unanimously consent with an "independent" director, partner, or managing member who is generally "designated by the lender and can presumably veto any suggestion of the SPE filing a voluntary bankruptcy petition."11 SPEs have served as a securitization tool for some time,12 so they have had at least some success.
Kingston Square Associates
In re Kingston Square Associates13 is an illustration of the limitations of an SPE as a bankruptcy proofing device. The SPE's organizational documents required that the secured lender's designee on the board of directors consent to any bankruptcy filing. Each of the 11 SPE debtors was owned or controlled at one time by the same principal, and each was subject to a limitation on commencing a bankruptcy. When the SPE's properties were in foreclosure and the board concluded that following the designated procedures to commence voluntary bankruptcy would be futile, the principal paid a law firm to solicit unsecured creditors to file involuntary chapter 11 petitions. Some trade creditors and professionals who worked for the debtors filed the petitions, and the secured lenders sought to dismiss the involuntary cases on the ground that the collusion between the debtors and the petitioning creditors constituted bad faith under Bankruptcy Code Section 1112(b).
The court held "that a bankruptcy petition will be dismissed if both objective futility of the reorganization process and subjective bad faith in filing the petition are found."14 Accordingly, the court further held that "although the debtors plainly orchestrated the filing of the involuntary petitions, they had reason to believe that reorganization was possible and did not circumvent any court-ordered or statutory restrictions on bankruptcy filings such that, absent any evidence of objective futility of the reorganization process, the cases ought not be dismissed now."15 No formal record had been developed regarding the futility of reorganization, and there were indications that reorganization was possible (e.g., a favorable appraisal and expressions of interest in purchasing the properties), so the court denied the motions to dismiss.
The court was fairly dismissive of the lenders' argument against permitting debtors to circumvent the antibankruptcy provisions in their governing documents. "The Movants may feel bruised because the Respondents outmaneuvered what the Movants thought was an iron-clad provision in the corporate by-laws preventing a bankruptcy filing, but this does not mean that, without more, the petitions must be dismissed."16 The court also had harsh words for the lenders' designee on the board, stating that "he completely ignored the limited partners' plight in the face of foreclosure actions instituted by the group which placed him on the boards of directors...and saw to it that he was paid fees, even though the consequence of foreclosure would be not to simply injure but to eliminate the limited partners' interests." As the court put it: "If he was the 'independent' director, it was in name only."17 One issue on which the court expressly refused to opine was whether it should nullify the bankruptcy proof provision in the debtors' bylaws.18
In 2009, In re General Growth Properties, Inc.,19 revisited the question whether bankruptcy cases should be dismissed for bad faith if debtor SPEs have maneuvered around antibankruptcy provisions in their organizational documents. Relying in part on Kingston Square Associates, the court denied the secured lenders' motions to dismiss the chapter 11 cases of various debtors owned directly or indirectly by General Growth Properties, Inc. (GGP), a real estate investment trust and the parent of approximately 750 wholly owned subsidiaries, joint venture subsidiaries, and affiliates. The bankruptcy cases commenced in the wake of the credit market crisis, which prevented GGP and hundreds of its affiliated entities from refinancing their debt and led them to file what was then the largest real estate bankruptcy case in history.20 The debtors were project-level SPEs holding single real estate assets (e.g., shopping centers, more than 200 of which the group of companies owned or managed). In some cases, provisions in the organizational documents of the SPEs indicated that they were intended to be bankruptcy remote. Specifically, much as in Kingston Square Associates, there were provisions requiring the unanimous consent of one or more "independent" directors or managers before the SPEs could file for bankruptcy.
Although the two cases resolved in much the same way, General Growth Properties in some respects contrasts with Kingston Square Associates. In Kingston Square Associates, the debtors concluded that they could not file a voluntary bankruptcy case in the face of the veto power of the secured lender's board designee, so they proceeded to orchestrate an involuntary bankruptcy filing. In General Growth Properties, instead of bypassing an uncooperative board member, the debtors simply removed the lenders' designees and replaced them with more cooperative board members, who then approved the voluntary bankruptcy.21
The court in General Growth Properties assessed the merit of that rather bold maneuver and rejected the lenders' argument of bad faith. The court held that "it cannot be said that the admittedly surreptitious firing of the two 'Independent Managers' constituted subjective bad faith on the part of the Debtors sufficient to require dismissal of these cases," since "[t]he corporate documents did not prohibit this action or purport to interfere with the rights of a shareholder to appoint independent directors to the Board."22 As support for this conclusion, the court reasoned that "the Independent Managers did not have a duty to keep any of the Debtors from filing a bankruptcy case," but instead "[a]s managers of solvent companies charged to act in the same fashion as directors of a Delaware corporation, they had a prima facie fiduciary duty to act in the interests of 'the corporation and its shareholders.'"23
The court also relied on Kingston Square Associates, which the General Growth Properties court described as involving a far more egregious action that was "suggestive of bad faith." As the court noted, the debtors' collusion with the petitioning creditors in Kingston Square Associates was still insufficient to warrant dismissal, since "the collusion was not rooted in a 'fraudulent or deceitful purpose' but designed 'to preserve value for the Debtors' estates and creditors.'"24 The court found that the debtors' bankruptcy filings were likewise designed to preserve value for their estates and creditors. As the court stated forcefully: "It is clear, on this record, that Movants have been inconvenienced by the Chapter 11 filings....However, inconvenience to a secured creditor is not a reason to dismiss a Chapter 11 case."25 As in Kingston Square Associates, the court did not address whether the bankruptcy remote provisions in the SPEs' governing documents ought to be unenforceable in the first place as a matter of public policy.
DB Capital Holdings
In a 2010 opinion, the bankruptcy appellate panel for the Tenth Circuit, in In re DB Capital Holdings, LLC,26 upheld against a public policy challenge a provision in an LLC's operating agreement prohibiting the LLC from filing a bankruptcy petition or consenting to any bankruptcy filed against it. The debtor was a Colorado LLC formed to develop two condominium buildings. After defaulting on its secured loans and facing receivership, the LLC filed a chapter 11 case through its manager. The court granted a motion to dismiss that one of the LLC's members filed on the ground that the manager had acted without authorization and in bad faith.
In doing so, the court rejected the debtor's argument that the antibankruptcy provision in the operating agreement should be void as against public policy. The court reasoned that "all of the case law upon which Manager relies for this assertion 'involves a debtor's agreement with third parties to waive the benefits of bankruptcy,'" and the "Debtor has not cited any cases standing for the proposition that members of an LLC cannot agree among themselves not to file bankruptcy, and that if they do, such agreement is void as against public policy, nor has the court located any."27 In response to the debtor's argument that the antibankruptcy provision had in fact been inserted into the operating agreement at the behest, and solely for the benefit of, the secured lender, the court said it found no evidence to support that contention. Therefore, the court declined to opine "whether, under the right set of facts, an LLC's operating agreement containing terms coerced by a creditor would be unenforceable."28 Arguably in dicta, the court further supported its conclusion by reasoning that the operating agreement limited the manager's authority to operating the business "as presently conducted" and prohibited him from doing "any act that would make it impossible to carry on the ordinary business of the Company," two provisions the court found incompatible with the manager's filing of a bankruptcy case.
DB Capital Holdings indicates that, under the right set of facts, a court may enforce, even against a public policy challenge, provisions in a borrower's organizational documents that effectively prevent the borrower from voluntarily filing bankruptcy. However, lenders ought not rely too heavily on this holding. Apart from being unpublished, the holding is also rather narrow, in that the court expressly declined to say whether antibankruptcy provisions would be enforceable if there was evidence that they were coerced.29 It seems that in most cases the borrower would be able to present such evidence.30 It also seems that, if this evidence were presented, a court ought to invalidate an antibankruptcy provision.31 To do otherwise would elevate form over substance, since a provision of this kind achieves the same result as the advance contractual waivers that courts have routinely rejected as against public policy.
Much as in Kingston Square Associates, the DB Capital Holdings debtor ultimately became involved in an involuntary bankruptcy case filed by unsecured creditors.32 In DB Capital Holdings, during relief from stay proceedings the bankruptcy court rejected as against public policy the debtor's purported waiver, as part of a prepetition forbearance agreement, of its right to oppose stay relief, as too closely approximating a waiver of the right to file bankruptcy in the first place.33 These cases illustrate that even the most ironclad protections against a borrower voluntarily placing itself in bankruptcy will not necessarily keep the borrower out of bankruptcy court, since its other creditors may place it there if they feel threatened by a dominant secured creditor.
In addition, lenders inserting themselves or their designees into the borrower's management as "independent" directors or managers, with veto power over the borrower's ability to file bankruptcy, ought to be wary of what may come from the exercise of that power. To the extent a lender or a lender's agent is deemed to have exercised managerial authority over a borrower, it naturally follows that the lender may be subject to fiduciary duties. If, by refusing to authorize a bankruptcy, the lender has elevated its own interests above those of its principal, the lender may be liable for breach of fiduciary duty.34 This principle is broad and would seem to apply regardless of the precise nature of bankruptcy proofing device.35
Ultimately, lenders should probably assume that any loan they make could draw them into bankruptcy court, no matter how hard they try to avoid it. Lenders can attempt to minimize the fallout by avoiding riskier loans or by hedging or insuring against the riskier loans they do make. While recognizing the creativity that goes into devising bankruptcy proofing provisions (which may serve their purpose well enough, though by no means perfectly), one may ask whether the energy that goes into crafting bankruptcy proof loans would be better spent elsewhere. An attorney with clients who are considering becoming a lender's designee to an SPE borrower would be well served to advise them to balance the benefits of the post36 against their fiduciary obligations.
1 See In re Cole, 226 B.R. 647, 652 (B.A.P. 9th Cir. 1998).
2 In re Weitzen, 3 F. Supp. 698 (S.D. N.Y. 1933).
3 Federal Nat. Bank v. Koppel, 253 Mass. 157 (1925).
4 In re Weitzen, 3 F. Supp. at 698-99.
5 See, e.g., In re Cole, 226 B.R. at 651-52; In re Shady Grove Tech Ctr. Assocs. Ltd. P'ship, 216 B.R. 386, 390 (Bankr. D. Md. 1998); In re Gulf Beach Dev. Corp., 48 B.R. 40, 43 (Bankr. M.D. Fla. 1985); In re Tru Block Concrete Prods., Inc., 27 B.R. 486, 492 (Bankr. S.D. Cal. 1983); In re Pease, 195 B.R. 431, 435 (Bankr. D. Neb. 1996); Giaimo v. Detrano (In re Detrano), 222 B.R. 685, 688 (Bankr. E.D. N.Y. 1998); Shaw Steel, Inc. v. Morris (In re Morris), 1998 WL 355510, at *8 (Bankr. N.D. Ill. June 30, 1998); Johnson v. Kriger (In re Kriger), 2 B.R. 19, 23 (Bankr. D. Or. 1979).
6 Samantha J. Rothman, Lessons from General Growth Properties: The Future of the Special Purpose Entity, 17 Fordham J. Corp. & Fin. L. 227, 229 (2012).
8 Id. at 230.
9 Id. at 228.
10 Id. at 230-31.
11 Id. at 231-32. The precise designation of the lender designee depends upon the type of business organization. For example, corporations are governed by a board of directors, and a lender designee at an SPE corporation would generally be referred to as an independent director. LLCs, by comparison, are owned by members and can be either member-managed or manager-managed. Certain members may act simultaneously as managers or be endowed by the LLC's operating agreement with specified managerial powers. Thus, the lender designee may be referred to as an "independent manager," an "independent member," or "independent managing member." The lender or its designee may be a "special purpose member" of the LLC.
12 Id. at 228.
13 In re Kingston Square Assocs., 214 B.R. 713 (Bankr. S.D. N.Y. 1997).
14 Id. at 734.
15 Id. at 714-15.
16 Id. at 736.
18 Id. at 737.
19 In re General Growth Props., Inc., 409 B.R. 43 (Bankr. S.D. N.Y. 2009).
20 Jesse Cook-Dubin, New York Bankruptcy Court Topples Contractual Barriers to Filing Chapter 11: Part II, Am. Bankr. Inst. J. 16 (Dec./Jan. 2010).
21 In re General Growth Props., Inc., 409 B.R. at 67-69.
22 Id. at 68.
26 In re DB Capital Holdings, LLC, 463 B.R. 142, 2010 WL 4925811 (10th Cir. B.A.P. Dec. 6, 2010).
27 Id. at *3.
29 See Alvin L. Arnold & Marshall E. Tracht, Bankruptcy: LLC Agreement Can Waive Right to Bankruptcy, Real Est. L. Rep. 8 (Jan. 2011); Steven G. Horowitz, LLC Agreement Prohibiting Bankruptcy Filing Held Enforceable, Commercial Real Estate Financing: Strategies for Changing Markets and Uncertain Times, ST053 ALI-ABA 171, 174-75 (2012) [hereinafter Horowitz] ("[T]he decision should not be viewed as granting carte blanche approval to pre-petition agreements waiving bankruptcy protection.").
30 Horowitz, supra note 29, at 174-75.
31 Sheldon L. Solow & Uday Gorrepati, Can Lenders Prevent LLC Bankruptcy Filings? A Recent Decision Highlights the Debate, 128 Banking L.J. 220, 224 (2011) [hereinafter Solow & Gorrepati].
32 In re DB Capital Holdings, LLC, 454 B.R. at 809.
33 Id. at 814-16.
34 Solow & Gorrepati, supra note 32, at 224.
35 A special purpose member is a member of the LLC only in the most abstract sense. Generally speaking, the special purpose member is not required to make any capital contribution, and the operating agreement specifies that, except for the right to authorize or reject any proposed bankruptcy filing, the special purpose member has none of the rights or duties generally attributed to LLC members or managers. A prudent lender would also have the operating agreement provide that it could not be amended without the consent of the special purpose member, so that management could not do away with this bankruptcy veto by amending the operating agreement.
36 In Kingston Square Associates, the lenders' "independent director" on the borrowers' boards, a former vice president of the lenders, was paid $25,000 a year for his service on the board, even though, as the court itself observed, he did very little to earn that money.