May 25, 2017

A lender’s “golden share” may not be so golden

A recent case before the Bankruptcy Court for the Northern District of Illinois has called into question the efficacy of a lender’s “golden share” to restrict a limited liability company from filing for bankruptcy. A “golden share” provides its owner the right to block certain actions of a business. Lenders have used their special member status, bestowed by at least a one percent membership interest in the entity, to try and block a borrower’s right to file for bankruptcy, as a minority owner of the borrower. The golden share and blocking rights generally arise as part of a forbearance agreement whereby a borrower may grant a lender a share in its corporate entity in exchange for forbearance. In such cases, the governance documents are amended to assign the lender a one percent interest in the borrower and require unanimous consent for major corporate decisions, such as filing for bankruptcy.

The Bankruptcy Code permits any debtor to commence a voluntary petition by filing a bankruptcy petition. Business entities, however, must have corporate authority to file a valid petition or its petition is subject to dismissal as a bad faith filing. In cases where a lender holds blocking rights under the corporate governance documents to prevent a bankruptcy filing, the lender has often sought to dismiss a filing made without lender consent.

Whether a lender can use its golden share to either block a borrower’s ability to file for bankruptcy or to dismiss the case as bad faith filing due to lack of unanimous consent has been recently addressed by several courts. The court in In re Lake Michigan Beach Pottawattamie Resort LLC held that the blocking provision in that case was void and could not prevent the debtor from filing for bankruptcy.

In Lake Michigan Beach, the debtor amended its organizational documents to appoint its lender as a “Special Member” as part of a forbearance agreement between the parties. As a Special Member, the lender was granted the power to block the debtor from taking any material action without the lender’s consent, including filing for bankruptcy. The documents provided:

Notwithstanding anything provided in the Agreement (or other provision of law or equity) to the contrary, in exercising its rights under this Section, the Special Member shall be entitled to consider only such interests and factors as it desires, including its own interests, and shall to the fullest extent permitted by applicable law, have no duty or obligation to give any consideration to any interests of or factors affecting the Company or the Members.

The court recognized that the lender required this provision because “a simpler, absolute prohibition against filing for bankruptcy will likely be deemed void as against public policy.” However, the court concluded that the blocking provision in the amended operating agreement was similarly void as against public policy as it removed lender’s fiduciary obligations (as a member of the entity) to the borrower and replaced them with the lender’s self-serving right to block material actions, even if such actions were taken in the best interest of the debtor. The court held that the blocking provision was void under Michigan law (the governing law under the documents) as Michigan law provides that members of an LLC have a duty to consider the interests of the LLC and not only their own interests. The Michigan law provides that:

(1) A manager shall discharge the duties of manager in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in a manner the manager reasonably believes to be in the best interests of the limited liability company.

The court also held that the blocking provision was void under bankruptcy law which provides for a debtor’s right to file for bankruptcy. The court cautioned that it was the specific language in the debtor’s operating agreement that rendered the blocking provision void as it eliminated any fiduciary obligations of the lender-member. Had the provision allowed for the lender to consider the interests of the entity and its creditors and vote in favor of bankruptcy, that type of provision in and of itself may not have been void. The court added, “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.”

Yet another court, however, in Delaware held that any blocking provision to a debtor’s right to file bankruptcy is void as against public policy. The Court in In re Intervention Energy Holdings, LLC held that the lender’s golden share in that case could not restrict an entity’s inherent right to file for bankruptcy. The court held that “[i]t is a well settled principle that an advance agreement to waive the benefits conferred by the bankruptcy laws is wholly void against public policy.” The court in Intervention Energy appears to take the ruling of Lake Michigan Beach even further such that no blocking provision with respect to a debtor’s right to file for bankruptcy would be tolerated.

The court in In re General Growth Properties, Inc. stated:

“If [the lenders] believed that an ‘independent’ manager can serve on a board solely for the purpose of voting ‘no’ to a bankruptcy filing because of the desires of a secured creditor, they were mistaken. … directors and managers owe their duties to the corporation and, ordinarily, to the shareholders. … “independent managers did not have a duty to keep any of the debtors from filing a bankruptcy case.” In that case, the debtor replaced blocking directors (assigned by the lenders) with directors that authorized the bankruptcy filing. The court denied the lenders’ motion to dismiss finding that the replacement managers’ authorization of the bankruptcy filing was not in bad faith.”

The moral of these cases is clear. Lenders should be aware that when organizational documents are modified to permit a lender to act as a blocking director or appoint a nominee to act on its behalf, under current trends an absolute prohibition against bankruptcy and/or any actions taken in violation of fiduciary duties to the borrower will likely be considered void. One approach that may survive scrutiny is to provide for a fiduciary duty of the special member to the LLC, but specifically carving out any fiduciary duty to a parent or other affiliate. In such case the special member-lender could withhold consent to a bankruptcy filing if such filing only benefits the LLC’s parent or affiliate but does not benefit the LLC itself.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client alert authored by: Miriam R. Stein, Associate

This alert originally appeared in the Summer 2017 Banking Focus newsletter.