Wednesday, July 13, 2016

Special Issue: Bankruptcy Remote Entities

By Bill Siegel

The purpose of a bankruptcy remote entity is to prohibit the entity from seeking bankruptcy protection without first obtaining approval from of all of its members or shareholders, one of whom is a creditor holding significant debt, presumably secured.  Yet, there are risks associated with such prohibitions.  Prohibiting a debtor from seeking bankruptcy protection may be violative of public policy and therefore, some courts have questioned their validity.

Until recently, a majority of courts upheld the dismissal of bankruptcy cases filed by such entities noting that the parties had the freedom to contract absent coercion.  Yet, some bankruptcy courts have seemed to chip away at the majority by examining the duty of management, the amount of equity held by the lender and the circumstances in which the lender was granted equity in the debtor.  

A recent case in the Delaware bankruptcy court exemplifies the risks associated with bankruptcy remote entities and the fiduciary duties attendant to seeking bankruptcy protection.  In In re Intervention Energy Holdings LLC, Case No. 16-11247(KJC), 2016 WL 3185576 (Bankr. D.Del.  June 3, 2016), a group of energy-related companies, Intervention Energy Holding LLC and its wholly-owned subsidiary Intervention Energy, LLC (collectively “Intervention Energy”), filed for bankruptcy protection.  The secured creditor filed a motion to dismiss arguing that it was a member of the limited liability company and unanimous approval of the members was required for Intervention Energy to file for bankruptcy.  Notably, the secured creditor had paid $1.00 for one unit in Intervention Energy pursuant to a forbearance agreement.  This one unit amounted to a .00005% interest in the debtor.  As part of the forbearance agreement, the operating agreement had been amended to require unanimous approval of all members before seeking bankruptcy relief.   

The debtor in response urged the court to follow In re Lake Michigan Beach Pottawattamie Resorts LLC, 547 B.R. 899, 912 (Bankr. N.D. Ill. 2016).  There, the court denied the lender’s request to dismiss the filing of a bankruptcy remote entity.  The court in Lake Michigan noted that bankruptcy remote entities are permissible so long as the operating agreement recognizes that there may be situations in which an independent director has the discretion to vote in favor of a bankruptcy filing, even if in doing, it violates the purpose for which the independent director was appointed.  Id at  912.  

The Intervention Energy Court noted that the relationship between the lender and Intervention Energy was that of a creditor and a debtor, and, as a minority member, the lender did not have a fiduciary duty to anyone but itself.  The Court further noted that certain restrictions required by special purpose entities (“SPE”) involving lenders are permissible.  For example, restrictions involving: (a) the amount of debt the entity can incur; (b) the activities relating to ownership and operation of certain collateral securing the debt; and (c) the ability of the entity to merge or dissolve, may be enforceable.  In addition,  the SPE may require the appointment of an independent director or member whose vote would be required to file bankruptcy.

Here, since the operating agreement eliminated any duty on its members to consider what was in the best interests of the limited liability company, the court ruled that the consent requiring bankruptcy was not enforceable as it was against public policy.  As a result, the court denied the lender’s motion to dismiss the bankruptcy case.

Similar to the holding in Lake Michigan, the court in Intervention Energy recognized that the lender owed no duty to the SPE in the event the SPE needed to file bankruptcy.  This was tantamount to a waiver which was in violation of public policy.  Nevertheless, just as in Lake Michigan, the Court in Intervention Energy went to some lengths to distinguish its ruling from the ruling in In re Global Ship Systems, LLC, 391 B.R. 193 (Bankr. S.D. Ga. 2007) where the secured lender had received 20% of the Class B stock at the time of the closing of its loan to the debtors.  In Intervention Energy, the lender had received an insignificant interest in the debtor  and that nominal level of equity seemed to sway the Intervention Energy court.

In summary, provisions giving the equity lender the right to prevent a bankruptcy filing will be upheld by courts as long as it appears that the lender has more than an insignificant interest in the bankruptcy remote entity.  That right will be strengthened if an independent person is appointed as a manager, member or director to represent the lender, and such independent person has been given the discretion to exercise his or her independent judgment to vote in favor of a bankruptcy filing, if required.

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